Call right: Overview, definition, and example
What is a call right?
A call right, also known as a call option, is a financial term that refers to the right of an investor or entity (usually the issuer) to buy back a security, such as a bond or preferred stock, from the holder at a predetermined price before the security’s maturity date. Call rights are typically included in financial contracts, particularly in the case of callable bonds or preferred stocks. This allows the issuer to repurchase the securities early, often if interest rates decrease or if they wish to reduce their debt or outstanding shares.
For example, a corporation may issue callable bonds with a call right, allowing it to repurchase the bonds before the maturity date at a set price, typically at a premium to the face value.
Why is a call right important?
A call right is important because it provides the issuer with flexibility to take advantage of favorable financial conditions, such as lower interest rates, by redeeming bonds or preferred stock before the scheduled maturity. This can help the issuer save on interest payments or reduce its overall debt burden.
For investors, call rights can introduce some uncertainty. While they may benefit from receiving regular interest payments or dividends, the call right means the issuer could redeem the securities early, possibly when interest rates are low, which might result in the investor having to reinvest the proceeds at a lower rate.
Understanding call right through an example
Imagine a company issues a bond with a 5% annual interest rate and a maturity date of 10 years. However, the bond includes a call right, which allows the company to repurchase the bond after 5 years at a premium. If interest rates drop to 3% after 5 years, the company might exercise its call right to buy back the bond at the premium price. This allows the company to reduce its interest costs by refinancing the debt at the new, lower interest rate.
In another example, a company may issue preferred stock with a call right, giving the company the option to buy back the stock after 5 years at a fixed price. If the company’s financial position improves or its stock price decreases, it might choose to redeem the preferred stock early to avoid paying higher dividends in the future.
An example of a call right clause
Here’s how a call right clause might look in a contract:
“The Issuer shall have the right, but not the obligation, to call and redeem the bonds in whole or in part at any time after [insert date] at a price equal to [insert price] plus accrued interest, subject to the terms and conditions set forth in this Agreement.”
Conclusion
A call right provides issuers with flexibility to redeem securities early when it is financially advantageous, such as in a declining interest rate environment. While call rights benefit issuers by reducing their long-term financial obligations, they may pose a risk to investors, as they could be forced to reinvest the proceeds at a lower return. Understanding call rights is important for both issuers and investors to manage the risks and opportunities associated with callable securities.
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.