call provision

Call provision

An embedded option granting a bond issuer the right to buy back all or part of an issue prior to maturity.

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call provision

The stipulation in most bond indentures that permits the issuer to repurchase securities at a fixed price or at a series of prices before maturity. This provision operates to the detriment of investors because calls on high-interest bonds usually occur during periods of reduced interest rates. Thus, an investor whose bond is called must find another investment, often one that provides a lower return. Certain preferred stock issues are also subject to call. Also called call feature. See also make-whole call provision.

Case Study Unlike most long-term corporate and municipal bonds, U.S. Treasury bonds cannot generally be called prior to their scheduled maturity dates. The U.S. Treasury last issued callable bonds in 1984 and even these bonds could only be called in the five years prior to maturity. All U.S. Treasury bonds issued after 1984 have been noncallable. The Treasury's inability to call its bonds prior to their scheduled maturities proved to be a bonanza for investors who purchased long-term Treasury securities in the mid-1980s when interest rates were relatively high. The U.S. Treasury was required to continue paying very high interest rates on this debt into the next decade, when market interest rates had declined substantially. If these bonds had been issued with a call provision, the Treasury could have retired bonds with coupons of 11% and 12% and issued new bonds with coupons of 5% and 6%, thereby saving taxpayers billions of dollars in interest expense.

Why should I check a bond's call provision before buying it? Which types of bonds have these provisions?

Bond issuers seem to call their bonds in when bond investors least want to receive their principal backafter interest rates have already dropped. If you pay close attention to a bond's call provisions, however, you can avoid experiencing losses of principal (that is, you can avoid paying big premiums for high-coupon bonds that are about to be called in at lower premium prices or, worse yet, at par). Furthermore, if you are a short maturity buyer (let's use three years for an example), you may be able to earn a higher yield for the three-year period by purchasing a longer cushion bond that is callable in three years instead of buying a bond that matures in three years. Reason: the market will generally reward you with a higher yield to the call on the cushion bond (due to the uncertainty of its actually being called in three years) compared with the yield that the market will provide you on a similar bond that will definitely mature in three years. It is important to mention that if you invest in a cushion bond and it is not called, you will be faced with the choice of either holding a longer bond than you may have intended to hold or liquidating at market value.

Stephanie G. Bigwood, CFP, ChFC, CSA, Assistant Vice President, Lombard Securities, Incorporated, Baltimore, MD