Understanding “Call” and Refunding Risk

One of the most difficult risks for investors to understand is that posed by “call” and refunding provisions. If the bond’s indenture (the legal document that spells out its terms and conditions) contains a “call” provision, the issuer retains the right to retire (that is, redeem) the debt, fully or partially, before the scheduled maturity date. For the issuer, the chief benefit of such a feature is that it permits the issuer to replace outstanding debt with a lower-interest-cost new issue.

A call feature creates uncertainty as to whether the bond will remain outstanding until its maturity date. Investors risk losing a bond paying a higher rate of interest when rates have declined and issuers decide to call in their bonds. When a bond is called, the investor must usually reinvest in securities with lower yields. Calls also tend to limit the appreciation in a bond’s price that could be expected when interest rates start to slip.

Because a call feature puts the investor at a disadvantage, callable bonds carry higher yields than noncallable bonds, but higher yield alone is often not enough to induce investors to buy them. As further inducement, the issuer often sets the call price (the price investors must be paid if their bonds are called) higher than the principal (face) value of the issue. The difference between the call price and principal is the call premium.

Generally, bondholders do have some protection against calls. An example would be a bond that has a 15-year final maturity, noncall two years. This means the investor is protected from a call for two years, after which time the issuer has the right to call the bonds.

A sinking fund is money taken from a corporation’s earnings that is used to redeem bonds periodically, before maturity, as specified in the indenture. If a bond issue has a sinking-fund provision, a certain portion of the issue must be retired each year. The bonds retired are usually selected by lottery.

One investor benefit of a sinking fund is that it lowers the risk of default by reducing the amount of the corporation’s outstanding debt over time. Another is that the fund provides price support to the issue, particularly in a period of rising interest rates. However, the disadvantage—which usually weighs more heavily on investors’ minds, especially in a falling-rate environment—is that bondholders may receive a sinking-fund call at a price (often par) that may be lower than the current market price of the bonds.

Bond investors should be aware of the possibility of certain other kinds of calls. Some bonds, especially utility securities, may be called under what are known as Maintenance and Replacement fund provisions (which relate to upgrading plant and equipment). Others may be called under Release and Substitution clauses (which are designed to maintain the integrity of assets pledged as collateral for some bonds) and Eminent Domain clauses (which have to do with paying off bonds when a governmental body confiscates or otherwise takes assets of the issuer). Ask about these and any other special redemption provisions that may apply to bonds you are considering.

You can avoid the complications and uncertainties of calls altogether by buying only noncallable bonds without sinking-fund provisions. If you do buy a callable bond and it is called, be aware that its actual yield will be different than the yield to maturity you were quoted. So ask your financial consultant to tell you what the yield to call is as well.

Just as some issuers have the right to call your bond prior to maturity, there is a type of bond—known as a put bond—that is redeemable at your option prior to maturity. At specified intervals, you may “put” the bond back to the issuer for full face value plus accrued interest. In exchange for this privilege, you will have to accept a somewhat lower yield than a comparable bond without a put feature would pay.