Question on 'Calll Provision' for Bond Issues

Q. Which one is TRUE regarding call provision? A. Call Provision is an advantage to the bondholder B. Call Provision will benifit the issuer in times of declining interest rates C. Callable bond will trade at a price higher than an identical noncallable bond D. A nonrefundable bond provides more protection to bondholder than a noncallable bond - Dinesh S

I believe the answer is B. The call provision allows the issuer to call the bond and refinance the debt at a a lower cost if interest rates decline, so a callable bond should trade at a lower price than an identical noncallable bond. A noncallable bond provides more protection to the bondholder than a non-refundable bond, which is only protected from redemption that is funded by the issuance of debt at a lower interest rate.

And moving forward, If I am an issuer I will benefit from the decline of interest rate by decreasing (or to lessen) my barrowing cost (wich is the coupon payment) by retiring the bond w/ call provision (let say a bond with 10% CR) and issue another bond with much lower interest rate relative to the bond that is being called (let say after I retire the bond with 10% CR I will issue another bond with lower issue of 5% CR). Option C is incorrect, it refers to puttable bond not in callable bond.

I think its B

Agree with B.

Indeed, answer B.

B indeed

I agree with B. What’s a nonrefundable bond? Bonds that cannot be called using external financing?

OK we do not need any more agreement with B. The freaking answer is B. Non-refundable means their is a restriction in the indenture that prevents the company from issuing new bonds within some time period after calling existing bonds. They can absolutely call them if they win Powerball or something.

Everyone seems to be bang on target with ‘B’ as the correct answer. apcarlso, Non-Refundable Bonds are bonds issued by bond-issuers that cannot be retired, just to re-issue new bonds at a lower rate, but they can be surely be called-away for any other reasons. So they provide better Interest Rate Risk than their like ‘Callable Bonds’. But I still I don’t know how all this works in real (me - not from Finance) and what are the others reasons of retiring the bond, other than reissuing at a lower rate? It would be great if anyone could elaborate more on this and/or correct me if I am wrong. - Dinesh S

I guess another reason to retire a bond is that operations have provided sufficient cash to do so. If you don’t need to the debt financing, why take it on and pay interest?

apcarlso Wrote: ------------------------------------------------------- > I guess another reason to retire a bond is that > operations have provided sufficient cash to do so. > If you don’t need to the debt financing, why take > it on and pay interest? Presumably the firm’s project hurdle rate (and actual returns) are greater than its wacc. If not, you’re right they should return capital to investors.

Remember that if there is excess cash on hand, they can repay debt or distribute to equity holders. The first changes the capital structure of the company while the second probably doesn’t (depending on how they repay shareholders). Reasons for repaying debt: 1) Interest rates have dropped, credit spreads have dropped, company’s credit rating is up - any one of which lowers their cost of debt 2) They want to change the capital structure of the company. With all due respect to Modigliani and Miller which used to be CFA 1, there are lots of reasons why capital structure is relevant in the real world. Corps often issue equity to refinance debt. 3) The debt is collateralized by something they want to sell. 4) Cost of equity is cheap compared to cost of bonds because of market segmentation. 5) The bond needs to be called because of a sinking fund provision 6) The covenants in the indenture are overly restrictive including things like restrictions on leverage ratios. A company may have to call a bond issue and refund it before it can take on more debt. 7) Negative provisions in the covenants prevent the company from restructurings, or taking on new risky businesses. and probably a host of other reasons I can’t think of now.

Wow!! I understood all the reasons expect pt 5, even Schweser tried to explain Sinking Fund Provision in couple of paragraphs, but the concept never got through me. Why would firms hire a trustee to retire debts issued by them? Which one of the modes of retiring is preferred 1) Cash Payment to trustee to randomly retire bonds using a lottery mechanism or 2) Delivery of the Bond Itself, under what circumstances, a firm would use either of them? Sorry, if I am sounding too basic!! - Dinesh S

Sinking fund provisions in bonds are credit enhancements. A certain percentage of the outstanding bonds need to be repaid according to the sinking fund schedule or the bond is in violation of its covenants -essentially in default. The idea is that the indebtedness under that bond is being continually reduced so the probability of being able to repay the rest of the issue goes up. That idea sounds a little old-fashioned to me, but there are still plenty of sinking fund bonds issued. I am not actually sure what the exact role of the trustee is, except I always thought his primary purpose was to ensure and certify that the sinking fund provisions were met. The company pays the trustee who purchases the bonds. If the company did it themselves, compliance would be left to auditors or something and that’s not really their job. Maybe someone else can detail exactly what the trustee does (btw - sounds like a wicked easy job to me).

Also, as for why one company would choose a lottery sinking fund and another a pro-rata sinking fund, I have no idea. It seems to me that the lottery method is inferior for everyone because it adds needless risk to your bond investment. Nevertheless, most sinking funds are done that way. I thought of a few other reasons for bond calls: 7) Replacement fund provisions - Used by utilities a lot that says the bond can be called when the underlying collateral (say a power plant needs to be replaced) 8) Eminent domain provisions - If the govt takes the collateral, the bond is called.

boh-ring. JDV is a true asset to this forum. I’ll leave it at that. I’ll be surprised if you’re not paid for this, dude.

definitely B

Haven’t read all the choices, so far just the first two, and right now I’d say B is looking pretty good. I’ll give you further updates as I read through the rest of the question.

Bite me.