Fixed-Income Types: Callable Bonds

A contingency is a "what if" built into a bond indenture. It's a trigger event. It's a threshold. It's something which might happen, but might not happen. And if it does happen, the indenture is likely to have a __contingency provision__, which is the specific details about what will happen, and how it will affect all parties involved. The CEO of OptionFinance has called the financial manager in to discuss the issuance of a new bond to give the firm more flexibility in future funding. The immediate suggestion is to issue __callable bonds__. These bonds have an embedded call option for the issuer, meaning that OptionFinance can choose to "call" back the bond to itself before maturity, paying off the principal if it would like to. "Fixed price calls" specify that call price.

What sort of thing do you think would make OptionFinance want to call back a bond it has issued, to pay it off early?

Absolutely! If market interest rates decrease, then OptionFinance will really wish they could issue new debt at lower rates. That's the beauty of a callable bond; they can do exactly that.

No, if the market interest rate increases, then the OptionFinance team will feel pretty fortunate to have debt issued at a relatively lower rate already.

No, the firm's stock price isn't directly related to the firm's incentives to call the bond.

The indenture will spell out all of the details about how this works. The OptionFinance bond being designed will be typical, in that it will have a __call price__ at a premium that OptionFinance will pay in order to call the bond; they are planning on a price of 102. It will also have a __call date__, before which the bond can't be called. This is something to protect investors a little bit, and get them to buy the bond in the first place. There is a __call protection period__ in which the call option is not yet valid. The firm just has to service the debt until this period is over, which ends on the call date.

Suppose the bond is issued, and sometime shortly after the call date the bond yield falls. Who might benefit from the embedded call option in this callable bond?

No, the option definitely provides a benefit. The call option provides the right for early payment of the bond's principal, and that right has value.

No, remember that the call option is an option for the issuer and not the bondholder. So the issuer is certain to have a potential benefit from this option.

That's right! The issuer has the option to call the bond, and so the issuer is the party which benefits. The bondholder is at risk of the option being exercised, so it is a cost for the bondholder that is compensated with a higher bond price. This is referred to as __call risk__.

It won't be a free ticket for OptionFinance, though. There is the call date already, and they can't call the bond until at least then.

This contingency provision is really an __embedded option__. What does that suggest?

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Many callable bonds today have a __make-whole__ feature in the bond's indenture, which requires the issuer to pay a lot more than the call price if they choose to call the bond. The make-whole call will cost the issuer the present value of all future cash flows of the bond at some predetermined rate. This is a much better deal for investors, and makes it much less likely that the issuer will call the bond. It's added a lot of times so that the issuer can get cheaper financing, since investors don't require as much yield when they have the make-whole provision.

No, it can have a lot of value. But "embedded" means "stuck inside, sort of. Since these options pertain just to the bond, they are not separable from the bond.

Of course. Since these options pertain just to the bond, they are not separable from the bond

Many bonds have embedded options, which leave the issuer or the bondholder the rights to either settle the bond or convert it to something else. There are several types of embedded options. Some benefit only the issuer, and some benefit only the bondholder. These one-way benefits have a logical effect on the price of the bond and the resulting bond yield. For example, the embedded option of a callable bond benefits the issuer only.

A decrease in the market interest rate

An increase in the market interest rate

An increase in the stock price of OptionFinance

The issuer

The bondholder

Neither of them

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It has little value

It's not separable from the bond