What it means
The premium exists because a call is unfair to the investor by design. The issuer calls when rates have fallen, which is exactly when the bondholder can least easily replace the income, so the premium is a partial payment for that inconvenience.
Call schedules normally start high and step down. A ten year bond callable from year five might be redeemable at 103 in year five, 102 in year six, 101 in year seven and at par from year eight onwards.
For the issuer, the premium is the price of flexibility and it must be weighed against the interest saved. The relevant sum is simple: how many months of lower interest does it take to recover the one off premium and the costs of issuing replacement bonds.
The same phrase is used slightly differently in the options market, where the premium is what a buyer pays for a call option. Context makes the distinction clear, but it is a genuine source of confusion for people reading both bond and derivative documents.
Accounting treatment also matters. The call premium and any unamortised issue costs are typically recognised as a loss on early extinguishment of debt in the period the bonds are redeemed, which can create an awkward one off hit to reported profit.
In practice
Real-world examples.
Example
A hospital group redeems $80,000,000 of 6.5% bonds at a call price of 102, paying a call premium of 2% x $80,000,000 = $1,600,000. Because the new issue carries a 4.2% coupon, the finance committee approves the redemption on the basis that the premium is repaid in under a year.
Example
A retail investor holding 50 bonds bought at par receives a call notice at 101 and is paid 50 x $1,010 = $50,500. The $500 call premium softens the blow slightly, but she still has to reinvest at a yield roughly 1.5 percentage points below her old coupon.
Example
A private company's loan notes carry a call premium of 3% in years one and two, falling to 1% in year three and nil thereafter. The board postpones its planned refinancing by four months so the redemption falls after the step down, saving 2% on a $20,000,000 balance.
Formula
Calculation
Call premium per bond = call price - face value
Total call premium = call premium per bond x number of bonds
Payback period in years = total call premium / annual interest saved
A manufacturer has $50,000,000 of bonds outstanding with a 7% coupon and a face value of $1,000 each, so there are $50,000,000 / $1,000 = 50,000 bonds. The bonds are callable at $1,030.
The call premium per bond is $1,030 - $1,000 = $30, so the total premium is 50,000 x $30 = $1,500,000. That is the cheque the company writes over and above repaying the principal.
Refinancing at 5% cuts annual interest from $50,000,000 x 7% = $3,500,000 to $50,000,000 x 5% = $2,500,000, a saving of $1,000,000 a year. The premium is therefore recovered in $1,500,000 / $1,000,000 = 1.5 years, and everything after that is straight saving for the remaining life of the debt.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Ardenway Foods, an invented packaged goods manufacturer, had $60,000,000 of 8% notes outstanding with a call schedule of 104 in year four, 102 in year five and par from year six. Rates had fallen and the treasury team wanted to refinance at 5.25% immediately.
Calling in year four meant a premium of 4% x $60,000,000 = $2,400,000 plus roughly $500,000 of issuance costs, against an annual saving of (8% - 5.25%) x $60,000,000 = $1,650,000. The combined $2,900,000 cost would take $2,900,000 / $1,650,000 = about 1.76 years to recover.
Waiting twelve months to the 102 date would cut the premium to $1,200,000, but it would also mean paying the old 8% coupon for another year, giving up $1,650,000 of saving to avoid $1,200,000 of premium. In this illustrative case the arithmetic favoured calling straight away, and the finance director documented the comparison so the board could see both paths side by side.
Watch out
Common mistakes.
- Treating the call premium as pure profit for the investor, when it rarely compensates fully for the lost future interest.
- Ignoring unamortised issue costs and legal fees when working out whether an early redemption is worth doing.
- Confusing a bond call premium with an option premium, which is a completely different payment made by a buyer rather than an issuer.
Questions
People also ask.
Is the call premium paid on top of the accrued interest?
Yes, an investor typically receives face value, the call premium and interest accrued up to the redemption date.
Why do call premiums decline over time?
Because the amount of income the investor loses shrinks as the bond approaches maturity, so less compensation is required.
Are all callable bonds redeemed above par?
Not always, since many schedules end with a par call in the final years, and some structures allow redemption at face value from the first call date.
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