Thus, a make-whole call provision improves a firm's financial flexibility by capping the price of a successful bond tender offer.
To assess the cost of a make-whole call provision, we develop a structural credit spread model with stochastic interest rates, stochastic firm value, and endogenous default decisions.
The increased usage of make-whole calls indicates that borrowing firms are willing to offer additional yield to obtain the financial flexibility associated with a make-whole call provision. If the flexibility gained by the firm does not impose significant extra costs on bondholders, however, it is unclear why observed incremental yields have been as high as our analysis suggests.
The debt is a coupon bond with principal due at maturity and is either non-callable or has a make-whole call provision. The value of the firm's assets and the risk-free rate are assumed to be correlated stochastic processes with a constant correlation coefficient.
As emphasized in the introduction, firms gain financial flexibility when a make-whole call provision is attached to a bond.
In either case, exercise of a make-whole call provision or a tender offer can upset the investment strategy and force the institution to rebalance the portfolio at an inopportune time.
A quantile regression is chosen rather than a more standard OLS estimation to ensure that we are not underestimating the value to the firm of having a make-whole call provision in these situations.
(15) Thus, any make-whole call provision with a premium of 18.22 bp or more will reduce the ex post wealth transferred to bondholders.
(19) For make-whole call bonds, the predicted spread includes the incremental yield associated with that bond's make-whole call provision. The predicted spread for the make-whole call bonds is significantly higher in both the frictionless environment--221 (123) bp--and in the environment with frictions--211 (117) bp.
Thus, a firm is more likely to incorporate a make-whole call provision if the underwriter has significant experience underwriting make-whole callable bonds, if the firm recently issued make-whole callable bonds, and so on.
Our belief is that the high-risk/high-yield firm would be less likely to incorporate a make-whole call provision, all else equal, since this would force the firm to offer an even higher yield on its bonds.