callable bonds and make whole provisions

In short

A friend of mine once bought a bond that paid a handsome rate, and he slept well until the company called it back early. If you are holding a bond, or thinking about one, the call feature deserves a few minutes of your time. A callable bond lets the issuer repay you before the stated maturity date. A make whole provision means the issuer must pay a price built from the bond's remaining payments, so an early call costs the issuer more. Read the offering documents to see which kind you hold, and look for the call dates and call prices. Then ask what you would do with the money if the bond were paid off tomorrow. None of this is a trick.

The whole of it

What it is

I once watched my neighbor pay off his mortgage the year rates dropped. He was happy, and the bank had mixed feelings, because it lost an income stream it liked. A callable bond works the same way, only the roles are flipped. The company or government that borrowed from you holds the right to pay you back early.

A bond is a loan. You lend money, and the issuer promises interest payments plus the return of your principal on a set date called maturity. With a callable bond, the issuer keeps the option to repay the principal sooner, on dates and at prices spelled out in the bond's terms. The price paid at an early call is the call price. It often sits a little above face value, and the extra is called a call premium.

If you are holding a bond with a make whole provision, you hold a different kind of call. The issuer can still repay early, but the issuer must pay a price that makes you whole. That price rests on the present value of every payment you would have received had the bond run to maturity. Present value just means what a future dollar is worth today, once you adjust for a chosen interest rate. The effect is simple. An early call gets expensive for the issuer. It rarely happens by choice.

How it works

If you are wondering why anyone would sell a callable bond, the answer is flexibility. Say a company borrows at 6 percent. A few years later, market rates fall to 4 percent. The company would love to repay the 6 percent debt and borrow again at 4 percent, and a call feature lets it do exactly that.

That is good for the issuer. It is less good for the holder, who gets the money back just when rates are low and new bonds pay less. This is called reinvestment risk, which is the chance that your returned money has to go to work at a lower rate than before. Not fun.

Because of this, a callable bond may pay a higher rate than a similar bond that cannot be called. The higher rate is what the holder gets for taking on the call risk. Some callable bonds also come with call protection, a stretch of years at the start when the issuer cannot call the bond at all.

A make whole call runs on a formula. The issuer must pay the larger of two amounts. One is the face value of the bond. The other is the present value of the remaining payments, found by discounting them at a rate set in the bond's terms, and that rate is often a Treasury yield plus a small spread that the offering documents spell out. When the discount rate is low, the present value comes out high. The call turns costly.

The numbers, and where to find yours

A brokerage screen will not show you all of these numbers. They live in the bond's offering documents, which the issuer files with the Securities and Exchange Commission. You can search for them on EDGAR, the SEC's free public database. Look for the prospectus supplement or the indenture, which is the contract between the issuer and the bondholders. Search the text for the words redemption, optional redemption, or make whole.

The documents should name the first call date, the call price on each date, any call protection period, and the make whole spread. Your broker can also show a yield to call and a yield to worst. Yield to call is the return you earn if the bond is called on a given date. Yield to worst is the lowest return across every possible call date and maturity. FINRA, the Financial Industry Regulatory Authority, publishes investor education on callable bonds at finra.org, and the SEC's Investor.gov site explains the same terms in plain language.

Municipal bonds can have their own call rules. Their documents are posted on the Municipal Securities Rulemaking Board's EMMA site at emma.msrb.org, which is free to search.

A worked example

Let me tell you about a woman named Dolores. She bought one bond with a face value of $1,000 that pays 6 percent a year, and it matures in 10 years. Each year it pays 6 percent of $1,000, which is $60. The bond is callable in year 5 at a call price of $1,030, meaning face value plus a $30 premium.

In year 5, market rates fall to 4 percent, and the issuer calls the bond. Dolores gets $1,030 back, plus the interest owed to that date. Before the call, she was counting on $60 a year for 5 more years. Now she has $1,030 to invest. At 4 percent, that money earns $1,030 times 0.04, which is $41.20 a year. Compared with the $60 she expected, she gives up $18.80 a year. Over the 5 years that remained, $18.80 times 5 is $94. She felt it.

Now picture a second bond with the same terms, except it carries a make whole provision. The issuer wants to call it right after the year 5 payment, with 5 annual payments of $60 left, plus the $1,000 principal at the end. To keep the math plain, assume each payment arrives at the end of a year, and that the contract sets a discount rate of 4.5 percent compounded once a year. Here is the calculation, payment by payment.

The $60 due in year 1 is worth $60 divided by 1.045, which is $57.42. The $60 due in year 2 is worth $60 divided by 1.092, which is $54.94. The $60 due in year 3 is worth $60 divided by 1.141, which is $52.58. The $60 due in year 4 is worth $60 divided by 1.193, which is $50.29. The $60 due in year 5 is worth $60 divided by 1.246, which is $48.15. The $1,000 principal due in year 5 is worth $1,000 divided by 1.246, which is $802.57.

Add them up. $57.42 plus $54.94 plus $52.58 plus $50.29 plus $48.15 plus $802.57 comes to $1,065.95. The make whole price is the larger of that figure and the $1,000 face value, so the issuer would have to pay about $1,065.95. That is $35.95 more than the $1,030 plain call price. Every figure here is a made up number for Dolores, so a real bond will have its own spread, rate, and timing rules. The indenture controls.

Where it goes wrong

I have seen smart people trip on this, and it was never for lack of brains. The usual problem is reading only the headline rate. A bond showing a high yield may be showing yield to maturity, a figure that assumes the bond lasts to the end. If the issuer calls the bond early, that figure was never the real return.

Another snag is buying above face value. Say a bond trades at $1,060 and the issuer calls it at $1,030. The holder loses $30 on the call. The price paid matters as much as the rate.

A third snag is mixing up the two call types. A plain call at a fixed price can leave the holder short. A make whole call is built to protect the holder. They sound alike but act very differently.

Last, call dates vary from bond to bond. Some bonds are callable on one date only. Others can be called at any time after a set date, which is called a continuous call. Some carry a sinking fund, where the issuer must retire part of the debt on a schedule. Read the terms, since the bond's contract binds the issuer and the holder alike.

Questions to answer before you leave this page

Do you know whether your bond is callable, and on what dates? Have you found the offering documents on EDGAR or EMMA, and read the section on redemption? What is the call price, and is it above or below what you paid? Does the bond have call protection, and when does it end? Is there a make whole provision, and what spread does the contract set? What is the yield to worst, and does it still look right to you? If the bond were called next month, where would your money go, and what would it earn? Could you live with that answer?