Firms commonly incorporate make-whole call provisions in their newly issued debt, presumably to improve their ability to retire debt early if circumstances require.
While traditional fixed-price call provisions also cap the price of a successful tender offer, make-whole call provisions are a superior mechanism for improving financial flexibility for several reasons.
The willingness of firms to incorporate make-whole call provisions in new debt issues indicates that the perceived benefits of increased financial flexibility more than make up for the call provision's up-front cost.
Indeed, for the last three years of our sample (2002-2004), observed incremental yields declined to less than half of what they were when make-whole call provisions were first becoming prevalent (1995-1998).
Make-whole call provisions are beneficial to the firm in these situations because they function as a cap on the price of a 100% successful tender offer.
These screens result in an initial sample of 2,798 noncallable bonds, 2,251 bonds with fixed-price call provisions, and 3,166 bonds with make-whole call provisions.
Without additional controls, the incremental yield attributable to the make-whole call provisions in our sample appears to be approximately 5-7 bp.
Instead, make-whole premiums are usually set at 15% of the prevailing credit spread when the bond is issued (Powers and Sarkar, 2006), ensuring that the make-whole call provisions are well out-of-the-money when the bond is issued.
Our analysis, however, is based on comparing bonds with make-whole call provisions to their noncallable equivalents.
Several of our instruments reflect the increase in popularity of make-whole call provisions over time as displayed in Figure 1.
Thus, if make-whole call provisions are predominantly utilized by firms with an unobserved need for financial flexibility, we should observe lower credit spreads and again experience a downward bias in our estimated coefficients for the MW variable if endogeneity is not taken into account.