Call Premium

The call premium is like a "bonus" paid by a company or government when they choose to take back a financial instrument, such as a bond or preferred stock, before its original due date. A call premium aims to compensate investors for the early redemption of the security.

The call premium adds uncertainty to the potential returns on callable security. If interest rates fall and the security is called, investors may have to reinvest their funds at a lower interest rate. This reduces the overall yield they can earn. Callable securities typically offer higher products than non-callable securities with similar maturities and credit ratings to compensate for this potential risk.

• A call premium is the extra amount an issuer must pay the investor. This is when they call back a callable security before its maturity date. It compensates the investor for early redemption risk and potential reinvestment at lower interest rates.
• Callable securities, such as bonds, allow the issuer to redeem the security before its maturity date. This provides issuers with flexibility in managing debt and interest rate risk.
• Several factors influence the likelihood of an issuer calling a security. It includes prevailing interest rates, the issuer's financial situation, the call protection period, credit spreads, and market demand for callable securities.

Call premium can be defined as the "reward" or "compensation" paid by the issuer of a callable security to investors if the security is redeemed or called back before its scheduled maturity date. It represents the additional amount that investors receive on top of the security's face value, serving as a form of payment to offset the inconvenience of early redemption. The call premium comes into play when the issuer redeems security before its scheduled maturity date. Here's how it works:

1. Issuance of Callable Security: When a company or government entity issues a callable security, they include a call provision in the terms and conditions of the security. This provision grants the issuer the right, but not the obligation, to redeem the security before its maturity date.
2. Call Price: The call provision specifies the call price, which is the price at which the issuer can buy back the security from the investor if they decide to exercise their call option. The call price is typically set at a premium to the security's face value (or par value).
3. Call Date: The call provision also includes the call date, the earliest date the issuer can exercise its right to call the security. Call dates are usually set a few years after the security issuance, giving the issuer some flexibility in timing the redemption.
4. Call Decision: When interest rates decline, the issuer may find it advantageous to call back the existing securities and reissue new ones at a lower interest rate. This can help the issuer save on interest expenses and reduce borrowing costs.
5. Paying the Call Premium: If the issuer decides to exercise the call option, they must pay the investor the call price, including the security's face value and the call premium. The call premium is the additional amount compensating the investor for the early security redemption.
6. Impact on Investors: Early redemption can be good and bad for investors holding callable security. On the one hand, they receive the face value of the safety and the call premium, which can result in a one-time gain. On the other hand, they may have to reinvest their funds in a potentially lower interest rate environment, which can lead to lower future returns.

Here are the main types of call premiums:

1. Hard Call: A hard call provision allows the issuer to call back the security only on specific dates, known as "hard call dates." These dates are predetermined and stated in the terms of the guard at the time of issuance. Once a hard call date arrives, the issuer can redeem the security at the specified call price. If the issuer does not call the security on the hard call date, the call provision may become void, and the issuer loses the right to call the security until the next hard call date.
2. Soft Call: A soft call provision, also known as a "deferred call," allows the issuer to call back the security after a certain period has passed since the security's issuance. Unlike burdensome call provisions, soft call provisions don't have specific call dates. Instead, there is usually a call protection period during which the issuer is restricted from calling the security.
3. Make-Whole Call: A make-whole call provision is a type of call provision that ensures investors are fully compensated if the issuer decides to call the security before its scheduled maturity date. The call price for a make-whole call is determined by calculating the present value of the remaining cash flows the investor would have received if the security continued until maturity.
4. Callable at Par: In a callable-at-par provision, the issuer can call back the security at its face value (par value). This means that the call price is equal to the face value of the security, and the issuer does not pay any call premium to the investor.
5. Callable at Premium: Callable at a premium is the most common type of call provision. It allows the issuer to call back the security at a price higher than its face value. The call premium compensates the investor for the early security redemption and is typically expressed as a percentage of the face value.

Some key factors that can affect the call premium of callable security:

1. Interest Rates: One of the most significant factors impacting callability is prevailing interest rates. If interest rates in the market decline significantly after the issuance of the security, the issuer may be incentivized to call the existing securities and issue new ones at a lower interest rate. In such a scenario, the issuer can save on interest expenses, leading to a higher likelihood of calling the security.
2. Call Protection Period: The call protection period, also known as the non-call period, is a specific duration during which the issuer can't call the security. This period provides investors with some protection against early redemption.
3. Maturity Date: The time to maturity of the security plays a role in the issuer's decision to call the security. Suppose the security is close to its maturity date. In that case, the likelihood of calling it decreases. The issuer might prefer to let it run its course rather than redeem it early.
4. Credit Spread: The credit spread is the difference between the yield of a security and the yield of a comparable risk-free instrument. When the credit spread narrows, issuers may consider calling back their securities. This is because it becomes cheaper for them to borrow money.
5. Call Premium Amount: The call premium is the extra amount the issuer must pay to redeem the security early. Market conditions, interest rates, and the issuer's creditworthiness influence the level of the call premium. Higher call premiums may discourage issuers from calling the security, whereas lower call premiums may increase the likelihood of a call.

The call premium is typically a percentage of the security's face value (par value). To calculate the call premium, one will need the following information:

1. Face Value (FV): The face value, also known as the par value, is the nominal value of the security. It is typically the amount repaid to the investor at maturity.
2. Call Price (CP): The call price is when the issuer can call back the security. It is usually specified in terms of security. It can be equal to the face value (callable at par) or higher than the face value (callable at a premium).

Once you have this information, one  can use the following formula to calculate the call premium as a percentage:

Call Premium (%) = * 100

Let us understand it better with the help of examples:

Example #1

Suppose a fictional company, ABC Corporation, issues callable bonds with a face value of $1,000 and a call price of $1,050. The bonds have a call premium of 5%.

Call Premium (%) = * 100

Call Premium (%) = * 100 = (50 / 1,000) * 100 = 5%

In this example, the call premium for the callable bonds issued by ABC Corporation is 5% of the face value. If the company decides to call these bonds early, it will need to pay the bondholders an additional 5% of the face value ($50) as compensation.

Example #2

Let's consider another example. Suppose a well-known company issues a callable corporate bond. Company XYZ issues callable bonds with a face value of $1,000 and a call price of $1,080. The bonds have a call premium of 8%.

Call Premium (%) = * 100

Call Premium (%) = * 100 = (80 / 1,000) * 100 = 8%

Here, the call premium for the callable bonds issued by Company XYZ is 8% of the face value. Suppose the company chooses to call these bonds before their maturity date. In that case, they must pay the bondholders an additional 8% of the face value ($80) as compensation for the early redemption.

The critical aspects of its significance are:

#1 - For Issuers

1. Flexibility in Debt: Callable securities allow issuers to manage their debt obligations. When interest rates decline, issuers can take advantage of the lower rates by calling back existing higher-yielding securities and issuing new ones at a lower interest rate. This helps them reduce borrowing costs and improve their financial position.
2. Risk Management: Callable securities allow issuers to manage interest rate risk. By incorporating call provisions in their debt offerings, issuers can avoid higher interest rates if market rates drop. This reduces the risk of high-cost debt in a low-interest-rate environment.
3. Enhanced Borrowing Capacity: Including a call option can make the security more attractive to investors due to the potential for higher returns. As a result, issuers may find it easier to raise capital and expand their borrowing capacity in the market.

#2 - For Investors

1. Higher Yields: Callable securities typically offer higher yields than non-callable securities with similar maturities and credit ratings. This higher yield compensates investors for taking on the risk of potential early redemption and reinvestment at potentially lower rates.
2. Potential Capital Gain: If the issuer calls the security and redeems it before maturity, investors receive the call price, which may be higher than the market price at the time of the call. This can result in a capital gain for investors.
3. Interest Rate Risk: Callable securities expose investors to interest rate risk. If interest rates decline after the security purchase, the issuer may choose to call it, leading investors to reinvest their funds at lower prevailing interest rates.

This has been a guide to What is Call Premium. Here, we explain how to calculate it, its types, examples, factors, and significance. You can learn more about it from the following articles –

• Call Warrant
• Call Protection
• Call Price