Key Takeaways
- Call protection prevents bond issuers from repurchasing bonds for a set period, protecting investors.
- Bonds are called when interest rates drop, allowing issuers to reissue at lower rates.
- Call protection clauses stipulate periods, often 10 years for corporate and municipal bonds, and 5 years for utility bonds.
- Call protection benefits investors by ensuring a minimum time to benefit from bond price appreciation as rates fall.
- After the call protection period, bonds may be redeemed with a premium over face value.
What Is Call Protection?
Call protection prevents a bond issuer from calling away bonds held by investors for a specific length of time. A bond provision spells out this deferment period. After the call protection end date, a bond can be redeemed at any time. Issuers usually call an outstanding bond when interest rates in the economy fall and they can then offer bonds with lower rates, thus saving on what they must pay investors.
How Call Protection Works in Bonds
A bond is a fixed income security that is used by a company or a government to raise money. The funds raised by selling the bonds are typically intended for use in a specific project. Bonds have a maturity date which is the date on which the principal investment is repaid to the bondholders. As compensation for lending their money, the investors receive interest payments in increments from the issuer until the bond reaches its maturity or expiration date. These interest payments are known as coupon payments and are fixed for the duration of the bond contract until the bond reaches its maturity or expiration date. At that time, the investor’s principal is returned.
High-quality bonds are seen as mostly risk-free, but both issuers and buyers still face some risk. If interest rates rise while the bond is active, the investor misses out on better returns. If rates fall, the issuer misses a chance to borrow money more cheaply.
Important
Callable bonds may have ten years of call protection, while call protection on utility bonds is typically limited to five years.
Mitigating Risk with Callable Bonds
Companies issue callable bonds to protect against this risk. This means they can choose to buy back the bonds at their full face value or with a stated premium over face value and then issue new bonds at a lower rate of interest.
Companies will typically call back their bonds when prevailing interest rates decrease unless there is call protection in place. That stipulation allows the investor some time to take advantage of any appreciation in the value of their bonds.
Call protection is very helpful for bondholders if interest rates fall. It means investors have a guaranteed number of years to benefit, even if the market worsens.
Call protection is typically stipulated in a bond indenture. Callable corporate and municipal bonds usually have ten years of call protection, while protection on utility bonds is often limited to five years.
Real-World Example of Call Protection
Let’s assume a callable corporate bond was issued today with a 4% coupon and a maturity date set at 15 years from now. If the first call on the bond is ten years, and interest rates go down to 3% in the next five years, the issuer cannot call the bond because its investors are protected for 10 years. However, if interest rates decline after ten years, the borrower is within its rights to trigger the call option provision on the bonds.
The bond can be redeemed anytime after the call protection period ends. Call protection clauses often require paying investors a premium over the bond’s face value if it is retired early after the call protection period ends.
The Bottom Line
Call protection is a key feature for certain bonds that prevents issuers from repurchasing a bond for a specified period of time. Call protection benefits investors during periods of falling interest rates, allowing them to earn consistent returns from coupon payments and price appreciation without the risk of the bond being called. When rates fall, issuers typically repurchase and reissue bonds at lower interest rates to reduce their borrowing costs.
Before buying bonds, investors should be sure that they clearly understand a bond’s provisions, including the specific terms of call protection (if offered) and when a bond can be called.