Corporate Bonds (Debt Securities) Part 2
Callable Features of Bonds (Paying Off Bonds Early)
If you borrowed $1,000 from someone and you could pay it off four years later for $850, would you? If you had the cash you just might. Well corporations do the same thing. Let’s say that XYZ Corp. had a series of bonds outstanding coming due in the year 2010. The 2010 bonds are presently trading at $850. XYZ Corp. places an order with their registered rep. who handles their investments and places an order to buy up however many they wish. They can buy any amount they want as long as the bonds are trading. On lightly traded issues the company might make a ‘Tender Offer’. With a tender offer, the company would publish an announcement in a large financial newspaper such as “The Wall Street Journal” and offer to buy back their bonds for $850 each (sometimes a little more if they want to attract more bond holders). They can offer to buy back all of the issue or part of the issue. If they offer to buy back part of the issue, it will probably be on a first come, first served basis.
So far, we have discussed the company which goes into the marketplace to re-purchase their bonds or makes a friendly offer to buy back their bonds. There are also situations where the company can force the bondholder to sell back his bonds. This is the ‘Callable’ feature of the bond issue. Bonds can be either callable or non-callable. In either case, this feature will be present in the indenture. If the bond is callable, it will state in the indenture when it is callable and at what price. Generally, the company will have to pay a price for the bond which is slightly above par (usually $1,000 for corporate bonds). Further, the earlier the company calls the bonds, the higher the premium they will have to pay for the bonds. This is because the company is forcing the investor to disrupt his income flow.
The most common reason for companies and also municipalities to call a bond issue is because they issued the bonds when interest rates were high and they have now come down to a much lower rate. Remember, that when interest rates go down, bond prices rise. And when interest rates go up, bond prices decline. Nevertheless, you might be sitting with a bond trading today at $1,400 and the company has the right to call the bond in at $1,100. There’s nothing you can do. You knew the bonds were callable when you bought them. You agreed to the terms. The company would then probably sell a new bond issue to repay the bond holders for the bonds the company was buying back. This type of a transaction is called a ‘Refunding’. The new bond issue will have a lower interest rate. Thus, the company will be reducing its financing costs. Call protection is the amount of time before the bond is callable. By the way, the best call protection is a non-callable bond. Another thing, bonds are usually called on one of the two dates the interest is due. This makes the computations much easier.