What it means
Protection comes in two forms. Hard call protection is an outright prohibition for a set number of years, while soft call protection allows redemption but only on terms that make it costly, such as a high premium or a condition that the share price has reached a certain level.
The purpose is to give investors a floor on their income. Without protection, an issuer could redeem within months of issue if rates ticked down, and buyers would have little reason to accept a long dated coupon at all.
The length of protection follows market convention by sector. Long dated corporate bonds are often protected until roughly halfway through their life, while high yield issues commonly use a three or five year non-call period followed by a stepped call schedule.
Protection is worth real money and it is priced. All else equal, a bond with longer call protection carries a lower coupon than one that can be called sooner, because the investor is buying certainty rather than yield.
Make whole provisions occupy a middle ground. They technically allow redemption at any time, but the price is calculated so that investors receive roughly the present value of everything they would have been paid, which makes early calls unattractive except in special circumstances.
In practice
Real-world examples.
Example
An insurance company buying long dated corporate bonds to match 20 year liabilities insists on at least ten years of hard call protection. The lower coupon it accepts is a deliberate trade, because a call in year three would leave a gap in its matched cash flows.
Example
A high yield issuer prices a seven year bond with a three year non-call period, then a call schedule beginning at half the coupon as a premium. Investors accept the structure because the non-call period guarantees three years of high income before any refinancing can happen.
Example
A convertible bond includes soft call protection stating that the issuer may only redeem if the share price trades above 130% of the conversion price for 20 out of 30 consecutive days. The condition protects holders from being called away just before the conversion feature becomes valuable.
Formula
Calculation
Income over the protected period = coupon per bond x number of protected years
Comparison with an unprotected alternative = income if called and reinvested at a lower rate
Compare two $1,000 bonds over five years. Bond A pays a 6.5% coupon, so $65 a year, and has five years of hard call protection. Bond B pays a more attractive 6.8%, or $68 a year, but can be called after one year.
Bond A delivers 5 x $65 = $325 of coupon income across the five years, whatever happens to interest rates. That figure is contractually certain unless the issuer defaults.
Now suppose rates fall and Bond B is called at the end of year one, with the proceeds reinvested at 4.0%, or $40 a year. Bond B produces $68 in year one and then 4 x $40 = $160 over the next four years, a total of $68 + $160 = $228. The protected bond ends up $325 - $228 = $97 per bond ahead despite its lower headline coupon.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Selby Foundation, an invented grant making body, needed to lock in $400,000 of annual income to fund a ten year scholarship commitment. Its adviser presented two portfolios of $6,000,000 each.
The first yielded 6.9% and would generate $6,000,000 x 6.9% = $414,000 a year, but most of the bonds were callable within two years. The second yielded 6.6%, producing $6,000,000 x 6.6% = $396,000, with hard call protection running for the full ten years.
The trustees chose the protected portfolio despite the $18,000 annual shortfall, covering the gap from unrestricted reserves. Three years into the fictional scenario, market yields on comparable bonds had fallen to 4.3%, at which level the unprotected portfolio would almost certainly have been called and reinvested at roughly $6,000,000 x 4.3% = $258,000 a year, leaving the scholarship programme badly underfunded.
Watch out
Common mistakes.
- Comparing two bonds on coupon alone without checking how long each one is protected from being called.
- Assuming soft call protection is as strong as hard protection, when soft terms can be met and the bond redeemed anyway.
- Believing call protection guards against every risk, when it does nothing about issuer default or a fall in the bond's market value.
Questions
People also ask.
Does call protection make a bond safer?
It removes the risk of early redemption but has no effect on credit risk, so a protected bond from a weak issuer is still a weak bond.
How is call protection shown in bond documents?
Usually as a non-call period, written as NC5 or "non-call five", meaning the issuer cannot redeem for the first five years after issue.
Do government bonds have call protection?
Most modern sovereign bonds are simply non-callable for their entire life, so the concept mainly applies to corporate, municipal and agency debt.
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