40 years, but any maturity is legally permissible.^3 Of course, the effective maturity of
a bond declines each year after it has been issued. Thus, MicroDrive’s bonds had a 15-
year original maturity, but in 2004, a year later, they will have a 14-year maturity, and
so on.Provisions to Call or Redeem Bonds
Most corporate bonds contain a call provision,which gives the issuing corporation
the right to call the bonds for redemption.^4 The call provision generally states that the
company must pay the bondholders an amount greater than the par value if they are
called. The additional sum, which is termed a call premium,is often set equal to one
year’s interest if the bonds are called during the first year, and the premium declines at
a constant rate of INT/N each year thereafter, where INT annual interest and N
original maturity in years. For example, the call premium on a $1,000 par value, 10-
year, 10 percent bond would generally be $100 if it were called during the first year,
$90 during the second year (calculated by reducing the $100, or 10 percent, premium
by one-tenth), and so on. However, bonds are often not callable until several years
(generally 5 to 10) after they were issued. This is known as a deferred call,and the
bonds are said to have call protection.
Suppose a company sold bonds when interest rates were relatively high. Provided
the issue is callable, the company could sell a new issue of low-yielding securities if and
when interest rates drop. It could then use the proceeds of the new issue to retire the
high-rate issue and thus reduce its interest expense. This process is called a refunding
operation.
A call provision is valuable to the firm but potentially detrimental to investors. If
interest rates go up, the company will not call the bond, and the investor will be stuck
with the original coupon rate on the bond, even though interest rates in the economy
have risen sharply. However, if interest rates fall, the company will call the bond and
pay off investors, who then must reinvest the proceeds at the current market interest
rate, which is lower than the rate they were getting on the original bond. In other
words, the investor loses when interest rates go up, but doesn’t reap the gains when
rates fall. To induce an investor to take this type of risk, a new issue of callable bonds
must provide a higher interest rate than an otherwise similar issue of noncallable
bonds. For example, on August 30, 1997, Pacific Timber Company issued bonds
yielding 9.5 percent; these bonds were callable immediately. On the same day, North-
west Milling Company sold an issue with similar risk and maturity that yielded 9.2
percent, but these bonds were noncallable for ten years. Investors were willing to ac-
cept a 0.3 percent lower interest rate on Northwest’s bonds for the assurance that the
9.2 percent interest rate would be earned for at least ten years. Pacific, on the other
hand, had to incur a 0.3 percent higher annual interest rate to obtain the option of
calling the bonds in the event of a subsequent decline in rates.
Bonds that are redeemable at par at the holder’s option protect investors against
a rise in interest rates. If rates rise, the price of a fixed-rate bond declines. However, if
holders have the option of turning their bonds in and having them redeemed at par,
they are protected against rising rates. Examples of such debt include Transamerica’s
$50 million issue of 25-year, 8^1 ⁄ 2 percent bonds. The bonds are not callable by the
company, but holders can turn them in for redemption at par five years after the dateKey Characteristics of Bonds 153(^3) In July 1993, Walt Disney Co., attempting to lock in a low interest rate, issued the first 100-year bonds to
be sold by any borrower in modern times. Soon after, Coca-Cola became the second company to stretch the
meaning of “long-term bond” by selling $150 million of 100-year bonds.
(^4) A majority of municipal bonds also contain call provisions. Although the U.S. Treasury no longer issues
callable bonds, some past Treasury issues were callable.