- 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. 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 typically set equal to one year’s interest if the bonds are called during
the first year.
4.2 However, bonds are often not callable until several years (generally five to ten)
after they are issued. This is known as deferred call, and the bonds are said to
have call protection.
4.3 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.
4.4 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 will then have to reinvest the proceeds at the
current market interest rate, which is lower than the rate investors 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 non-callable bonds.
4.5 Bonds that are redeemable at par at the holder’s option protect the holder against
a rise in interest rates. If rates rise, the price of fixed-rate bonds declines.
However, if holders have the option of turning their bonds in and having them
redeemed at par, they are protected against rising rates.
- Sinking Funds
5.1 Some bonds include a sinking fund provision designed to facilitate the orderly
retirement of the issue. Typically, the sinking fund requires the firm to retire a
portion of the bonds each year. On rare occasions the firm may be required to
deposit money with a trustee, who invests the funds and then uses the
accumulated sum to retire the bonds when they mature. Usually, though, the
sinking fund is used to buy back a certain percentage of the issue each year. A
failure to meet the sinking fund requirement causes the bond issue to be thrown in
to default, which may force the company into bankruptcy; obviously, a sinking
fund can constitute a significant cash drain on the firm.