After the call date for a bond, the premium that will be paid is listed, sometimes with the words added: "or make whole." What does this mean? -- Charlie Ehm
The short answer is the short answer to so many questions about bonds: It depends on the bond. To be sure, you need to look at the indenture, which either your broker or the issuer should be able to dig up for you. If it's a corporate bond, you can try looking it up using
Edgar Online or
10K Wizard. (The form number is in the 424B category.)
Having said that, it's possible to outline the basics of bond calls -- optional, extraordinary and make-whole.
First let's review, for readers who aren't familiar with the concept, what a bond call is.
If a bond has a call, the issuer is entitled to return the investor's principal and cease all interest payments on or after the call date. In other words, before the bond matures.
Why would an issuer want to do that? Typically, because interest rates are lower than they were when the bond was first issued. In an exercise comparable to a homeowner refinancing a mortgage, the issuer can save money by issuing new bonds and using the proceeds to call the old bonds.
Obviously, this type of call benefits issuers and hurts investors, who face the prospect of reinvesting their money at lower interest rates. So why would anyone buy a callable bond? Because issuers, to entice investors to buy bonds with calls, pay higher interest rates on callable bonds than on noncallable bonds.
Investors should never be surprised to learn that their bonds are being called; the precise terms of the call -- the date after which it may be exercised, and the price investors will receive for their bonds -- are spelled out in the offering document, and should be explained to you by the seller.
Different call structures are typical for different classes of bonds -- municipal, investment-grade corporate and high-yield.
Most municipal bonds are callable, and callable municipals typically become callable 10 years after they are issued, at a price of 102 or, increasingly, 101. That means for each $1,000 of face value, you get $1,020 or $1,010. If a bond is callable at 102 after 10 years, it typically becomes callable at 101 after 11 years and at par after 12 years. Bonds that become callable at 101 after 10 years typically become callable at par after 11 years.
Investment-grade corporate bonds may be callable, although it's not as common now as it was 10 years ago, when interest rates were much higher. A long-term corporate bond typically will be callable in 10 years at a premium equal to half its coupon rate. For example, a 30-year corporate bond with an 8% coupon might become callable after 10 years at a price of 104. As with municipals, the call price declines to par, but over a 10- to 15-year period, says Bill Cunningham, director of corporate bond strategy at
An intermediate-term corporate bond -- a 10-year bond, say -- if callable, usually becomes callable after five years. Cunningham says there's no consistent pattern to the size of the premiums offered.
The situation is similar in the high-yield arena, where maturities are seldom longer than 10 years. A 10-year, high-yield bond typically becomes callable in five years at a premium equal to half its coupon payment, declining to par in the eighth year, according to Brian Hoffmann, a lawyer at
Cadwalader Wickersham & Taft
. For example, a 10-year bond with a 12% coupon might become callable at a price of 106 after five years, at 104 after six years, at 102 after seven years and at par after eight years.
All of these are so-called optional calls, to be exercised at the issuer's option in the event interest rates decline. If you can be called out of your bond at a premium after a certain date, that is an optional call, and you will be compensated for it in the form of a higher yield (than for an otherwise similar, noncallable bond) when you buy the bond.
But there are other types of calls, intended for completely different contingencies. These include extraordinary and make-whole calls, and they don't give the investor any additional yield. A bond may have both an optional call and an extraordinary or make-whole call.
The basic message of an extraordinary or make-whole call is this: The issuer doesn't expect to have to use it, but if it does, investors will be compensated, or "made whole." In some cases, the compensation can be quite lavish. That's why investors don't demand additional yield for them.
Again, the specific provisions depend on the type of bond.
Municipal bonds may have an extraordinary call (which may be called a make-whole call) in the event of an actual or financial catastrophe. Example of an actual catastrophe: The bond-financed toll road gets wrecked by an earthquake. Example of a financial catastrophe: The IRS declares the bonds taxable. In either case, the issuer will make investors whole by returning their principals in full. In some cases, issuers may promise that if their bonds are declared taxable, they also will pay investors a premium approximating the extra interest they would have received up to that point if the bonds had been sold as taxable bonds in the first place.
In corporate and high-yield land, the words make-whole call have a different and very specific meaning.
In a practice that has become very common over the last five years, corporate and high-yield bonds are issued with a make-whole call that says they may be called at any time for business reasons: a merger or acquisition, a restructuring, a spinoff, to name a few. Before the development of the make-whole call, companies would do a tender-offer in these situations. There's no real difference to the investor, but for issuers, the tender-offer process was a pain in the neck. The make-whole call "institutionalized the tendering process," Chase's Cunningham says.
The corporate or high-yield make-whole call is a windfall for the investor. The issuer agrees to pay the price for its bonds that corresponds to the yield of a Treasury security, plus a certain spread. For investment-grade bonds, the spread is anywhere from five to 15 basis points. For high-yield bonds, it's 50 to 75 basis points. In other words, yield levels much lower that the bonds would ever trade at in the market. An investment-grade bond that would trade at the Treasury yield plus even 15 basis points, for example, is a very high-quality bond indeed. The assumption is that the bond in question is of a somewhat lower quality, and so would always trade at a much higher yield.
Remember that buyers of bonds (or of anything) want to buy at low prices and sell at high prices. In bonds, low prices correspond to high yields, and high prices correspond to low yields. By buying your bonds at a low yield, an issuer exercising a make-whole call is buying your bonds at a high price. The actual price depends on market interest rates, but it will always be much higher than the bonds would fetch on the open market.
If your bond says it's callable at a certain premium or make whole, I'm guessing it's a muni bond, where make whole means that you get your principal back in the event of a catastrophe. A corporate or high-yield issuer whose bonds have both an optional call and a make-whole call would always choose to exercise the optional call if possible, because the make-whole call would probably necessitate paying a higher price for the bonds.
TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.