What is a Call Price?
The call price (also known as “redemption price”) is the price at which the issuer of a callable security has the right to buy back that security from an investor or creditor. Call prices are commonly found in callable bonds or callable preferred stock. The call price is set at the time the security is issued and is known by reading the issue’s prospectus.
- he price at which a bond may be redeemed by the issuer before maturity. The price is set at the time of the issue. Call prices are set to reduce the issuer’s risk of default; that is, the issuer may have a concern that it will not be able to make all coupon payments and redemptions at maturity and may cut its losses by redeeming at the call price.
- The price at which a company may buy out its own preferred stock. The price is set at the time the preferred stock is issued. Reasons for exercising a stock call price include a desire to reduce dividends paid to preferred stockholders and a desire to increase earnings on common stock.
Understanding the Call Price
Callable securities are commonly found in the fixed-income markets and allow the issuer to protect itself from overpaying for debt by allowing it to buy back the issue at at a pre-determined price if interest rates or market prices change. This pre-determined price is the call price. For instance, if a company issues a bond paying a fixed coupon of 5% when interest rates are also 5%, they can use a call option to redeem that bond if interest rates drop to, say, 3% in order to be able to refinance their debt.
Because the call option benefits the issuer and not investors, these securities trade at higher prices to compensate callable security holders for the reinvestment risk they are exposed to and for depriving them of future interest income. Issuers therefore will pay a call premium. The call premium is an amount over the face value of the security and is paid in the event that the security is redeemed before the scheduled maturity date. Put another way, the call premium is the difference between the call price of the bond and its stated par value. For noncallable securities or for a bond redeemed early during its call protection period, the call premium is a penalty paid by the issuer to the bondholders.
How Does a Call Price Work?
The bond indenture will stipulate when and how a bond can be called, and there are usually multiple call dates throughout the life of a callable bond. Many corporate and municipal securities have 10-year call provisions.
For example, let’s consider an XYZ bond issued in 2000 and maturing in 2020. The indenture might stipulate that Company XYZ may call the bond in the second, fourth, and tenth year.
The call provision in the indenture sets forth the call price, which is what the issuer must pay to redeem the bond if it does so before maturity. In our example, the indenture might say, “The XYZ bond due June 1, 2020, is callable on June 1, 2004, at a price of 105% of par.” The indenture typically provides a table of call dates and corresponding prices as well.
note that the call price is normally higher than the face value of the bond, but it decreases the closer the bond is to maturity. For example, Company XYZ is offering 105% of face value if it calls the bond after four years, but it may only offer 102% if it calls the bond in ten years, when it is closer to its maturity date.
The difference between the face value and the call price is called the call premium. In our example, the call premium is 5% in 2004. In many cases, the call premium is equal to one year’s interest if the bond is called in the first year.
Significance of Call Price
For bonds, the call price and the timeframe that it can be triggered are typically set out in the bond indenture agreement. It allows the issuer of the bond to demand the buyer to sell the bond back, usually at its face value, along with the agreed upon percentage due. The premium may be fixed at an interest rate of one year. Based on the structure of the terms, the premium may decrease as the bond matures due to the amortization of the premium.
Some non-callable bonds may become callable after an initial period of time. When a company calls back a bond, it usually makes considerable economic gains in potential interest savings. The gains are made at the cost of a bondholder, who foregoes the lost interest income as the lender is not required to make interest payments after the bond is redeemed.
A business can also exert its right to call preferred shares if it decides to pay out the preferred shareholders and to discontinue dividend payments. It may be done to alter the capital structure of the company or to reduce preferred share dividend payments.
Investors must understand that the presence of an embedded call option in the bond influences the liquidity of the bond. A non-callable bond is worth more than a callable bond to the investors since the bond’s owner has the right to redeem a callable bond and deny the bondholder of the extra interest payments to which he/she would have been eligible if the bond had been retained to maturity.
Call Price and Call Premium
Callable securities are normally present in fixed-income markets. They allow the issuers to buy back the issued security at a specified price in the event of a change in the market price or interest rate. The price is denoted as the call price. Thus, callable securities enable issuers to protect themselves from increasing interest rates.
For example, if a business issues a bond that pays a fixed coupon at 4% and the interest rate is also 4%, it will utilize the call option to repay the bond if the interest rate decreases to, say, 2.5%, as it then can refinance the debt and save 1.5% in interest payments.
Since the call option favors the lender and not buyers, the bonds sell at high premiums to reimburse the bondholders for:
- Reinvestment risk
- Depriving them of potential interest income
Therefore, a call premium must be paid by the issuers to compensate bondholders. The call premium shall be a value over and above the security’s face value. Said another way, the difference between the bond’s call price and the specified par value is the call premium.
Non-callable securities or bonds that are redeemed early will incur steep penalties.
Why Does a Call Price Matter?
It’s extremely important for investors to realize the presence of an embedded call option in a bond affects the value of the bond.
A callable bond is worth less to an investor than a noncallable bond because the company issuing the bond has the power to redeem it and deprive the bondholder of the additional interest payments he’d be entitled to if the bond was held to maturity.
From the company’s perspective, having the ability to call the bonds adds value because the company is given the flexibility to adjust its financing costs downward if interest rates decline. But the company has to take the call price into account when determining whether or not it is worth it for them to refinance its debt.
Typically, bonds are called when interest rates fall so dramatically, the issuer can save money by floating new bonds at lower rates. If by the time of the call date interest rates have significantly dropped, the issuer is motivated to call the bonds because doing so will allow it to refinance its debt at a cheaper level. From another perspective, the issuer is incentivized to buy bonds back at par value, because as interest rates go down, the price of the bonds goes up.
Callable bonds are attractive to investors because they usually offer higher coupon rates than non-callable bonds. But as always, in return for this investment advantage comes greater risk.
If interest rates drop, the bond’s issuer will be strongly motivated to save money by replaying it callable bonds and issuing new ones at lower coupon rates. In these circumstances, the investor that holds the bonds will see his interest payments stop and obtain his principal early. If the investor then reinvests this principal in bonds again, chances are that he will be forced to accept a lower coupon rate that is in line with the prevailing (and lower) interest rates (called “interest rate risk”).