Call Protection

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21 Aug, 2024

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Call protection is a clause that can be included in bonds. It prevents the issuer from purchasing back the bond for a predetermined timeperiod. The amount of time the bond is guaranteed against loss is referred to as the deferral period. Bonds that can be called at a later date are called delayed callable bonds.

When interest rates decrease, bondholders can reap significant benefits from having call protection on their bonds. It indicates that investors will have a certain minimum number of years to start reaping the advantages of the security, irrespective of how bad the debt market becomes in the meantime.

What Is Call Protection?

Call protection measures limit the time range during which a bond may be called and may compel the seller to repay buyers a premium above the bond’s face value.
A clause of call protection can be included in bonds to prevent the issuer from purchasing the bond back for a predetermined time.
The issuer of callable bonds has the option to repurchase the bonds at their original face value at any time.
When interest rates in the economy as a whole go down, bondholders often call their holdings.

Call Protection Explained

Call protection refers to the protection against investment risk provided to bond investors by restricting the circumstances under which a bond issuer may choose to redeem bonds before the maturity date mentioned.

Bonds are fixed-income instruments that a firm or a governing institution can issue for financial fundraising. The proceeds from the sale of the bonds are normally used in a venture previously outlined. Bonds have a maturity date, the day the bondholders will receive a return on their major investment from the issuer.

The bond issuer will provide interest payments to the investors at regular intervals as a reward for using their funds till the maturity of the bond, also known as its expiry date. These interest or coupon payments are set throughout the bond contract. At that point, the initial investment made by the investor is returned to them.

Although it is commonly believed that high-quality bonds do not carry much investment risk, the reality is that both the bond's buyer and issuer are subject to some degree of uncertainty. For example, if interest rates rise throughout the bond's life term, the investor will have missed a chance to receive a greater return for the money they invested. Conversely, if interest rates go down, the organization or government that issued the call protection bond will miss out on the chance to borrow money at a more affordable rate.

Types

There are two types of call protection. Let us have a look at them.

#1 - Hard

Hard call protection refers to the initial type of call safeguarding that may be made available to bond buyers. It is a clause that forbids the bond creator from redeeming the bonds before a certain length of time has passed from the day the bonds were issued.

For instance, a bond with a maturity of twenty years may have a "hard call" protection that restricts the ability of the issuer to repurchase the bonds until ten years following the beginning of the bond's term. Bond purchasers are guaranteed to receive the bond's specified interest rate, sometimes the coupon rate, for at least ten years after purchasing the bond.

#2 - Soft

The second kind is known as soft call protection, which works differently. In tandem with a hard call provision, a soft call protection provision exists, and it is this provision's job to limit the period during which bonds may be called. If the bond issuer chooses to redeem the bond before the bond's maturity date, the clause mandates the bond issuer to pay the bond buyers a premium that is more than the bond's face value.

Example

Let's imagine that ABC Inc. decides to borrow $10 million through the bond market and then issues a bond with a 6% interest rate and a maturity period of ten years. The yearly interest payments that the corporation makes to its bonds come to 6% of $10 million, or $600,000 total.

When interest rates drop by 200 basis points (bps) to 4% three years after the date of issuance, the corporation is forced to redeem the bonds because of the loss of revenue. Following the provisions of the bond contract, it was distributed as having call protection of 5 years. As a result, the corporation will not be able to call the bonds for another two years.

Difference Between Call Protection And Refunding Protection

When a bond is said to be "called," it indicates that the issuer can repay the bond before its expiration rather than at the maturity date. Refunding a bond refers to the process of repaying the bond at its expiration through the use of a new debt issue.
Call protection is even more extreme; it bans the issuer from redeeming the bonds before a specific period for any reason and fully bars the issuer from doing so. On the other hand, refunding protection merely precludes redemption in one specific scenario.
Because of this, a bond may have a refunding protection period of five or ten years, but it may still be callable at any time. Contrarily, it can't be the other way around, where bonds have call protection, yet they may be refunded.

Frequently Asked Questions (FAQs)

How does call protection work?

A clause known as call protection can be included in some bonds that prevent the issuer from purchasing the bond back for a predetermined amount of time. The issuer of callable bonds has the option to repurchase the bonds at their original face value at any time. When interest rates in the economy as a whole go down, bondholders often call their holdings.

What is the difference between hard and soft call protection?

An issuer may incorporate a call protection clause into the bonds to entice investors to purchase these securities. This provision may be hard call protection, in which case the issuer is prohibited from calling the bond for that period, or it may be a soft call provision, in which case it takes effect only after the hard call protection has run its course.

What does call protection mean?

Call protection protects bond investors by limiting the situations under which bond issuers can redeem bonds before their maturity date.