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.
Given the beneficial characteristics of make-whole call provisions, it is not surprising that there has been an explosion in their popularity since the mid- 1990s.
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.
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.
To examine whether there is any change in the valuation of make-whole call provisions across time, we split our sample into three time periods: early (1995-1998), mid (1999-2001), and late (2002-2004).
Arguably, this negative experience reduced the attractiveness to investors of bonds with any type of call provision, even though make-whole call provisions are not subject to interest rate risk.