Call provision: Overview, definition, and example
What is a call provision?
A call provision is a feature in a financial contract, particularly in bonds or other debt instruments, that allows the issuer (borrower) to redeem or "call" the debt before its maturity date. This provision gives the issuer the option to repay the bondholder the principal amount (and sometimes accrued interest) early, usually at a predefined price, known as the "call price."
The call provision benefits the issuer by allowing them to take advantage of favorable market conditions, such as lower interest rates, by refinancing the debt at a lower cost. For the bondholder, however, the call provision can pose a risk because it limits the potential for future interest payments if the bond is called early.
Call provisions are often included in bonds or preferred stock offerings and can specify the exact terms under which the issuer has the right to call the securities, including the call date (when the call option becomes active), the call price, and any restrictions on how frequently the bond can be called.
Why is a call provision important?
A call provision is important because it provides flexibility to the issuer in managing their debt. For the issuer, the ability to redeem the bond early allows them to take advantage of changing financial conditions, such as lower interest rates or improved credit ratings, to reduce borrowing costs by issuing new bonds at a lower rate.
For investors, however, the call provision adds a level of uncertainty. Since the bond may be called before maturity, the investor could miss out on long-term interest payments and would need to reinvest the principal at potentially lower interest rates. To compensate for this risk, callable bonds typically offer higher interest rates to attract investors.
Understanding call provision through an example
Imagine a company issues a 10-year bond with a 5% annual interest rate. The bond has a call provision that allows the company to redeem the bond after 5 years, if it chooses, at a call price of $1,050 (the face value of $1,000 plus a $50 premium).
Five years later, interest rates have dropped, and the company decides to call the bond. The company redeems the bond early, paying the bondholders $1,050, even though the bond was originally issued with a 5% coupon rate. The company then issues new bonds at the lower prevailing interest rate to save on interest costs.
For the bondholder, although they received a small premium of $50, they will lose out on future interest payments over the remaining 5 years, and may need to reinvest their money at a lower rate.
An example of a call provision clause
Here’s how a call provision clause might appear in a bond agreement:
"The Issuer reserves the right to call, redeem, or repurchase the Bonds, in whole or in part, at any time on or after [insert call date], at a call price of [insert call price]. The call provision will be exercised by the Issuer upon providing written notice to the Bondholders at least [insert notice period] prior to the call date."
Conclusion
A call provision is a beneficial tool for issuers to manage their debt more effectively, particularly when market conditions change in their favor. It allows issuers to redeem bonds early and refinance at lower interest rates, potentially saving money over the life of the bond. However, it introduces a level of risk for investors, who may lose the opportunity for continued interest payments if the bond is called early. Investors typically expect higher yields to compensate for the added risk of a call provision, and the terms of the provision should be clearly defined in the contract to avoid misunderstandings.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.