Make-Whole Call Provision

What Is A Make-Whole Call Provision?

A Make-whole Call Provision refers to a call provision where an issuer has the right but not the obligation to buy back or retire a bond or other debt instrument at a premium before its maturity date. Its primary purpose is to safeguard bondholders or lenders against potential if that the issuer decides to redeem the bonds or pay off the debt before the specified due date. It is also called a Doomsday Call.

The security issuer pays off the principal amount with the coupon payments at their Net Present Value (NPV) on the date of premature redemption. The issuer settles the debt security before the stipulated period becomes due by paying off the total amount to the debtors.

• The make-whole call provision, or doomsday call, is a loan agreement or bond indenture clause that enables the issuer to retire a bond or pay off a loan in a lump sum before its maturity or due date to investors or debtors.
• It involves the outstanding coupon payments at NPV, accrued interest payments, and the principal amount payable by the issuer.
• Such a call provision benefits bondholders or lenders by protecting them against early redemption and ensuring they receive fair compensation against the reinvestment risk that arises if the issuer decides to call the bonds prematurely.

How Does A Make-Whole Call Provision Work?

A Make-whole Call Provision is a contractual clause commonly found in financial agreements, such as bond indentures or loan contracts. The purpose of this provision is to compensate the bondholder or lender for the early retirement of a bond or debt security. Also, it saves the issuer from interest rate risk or potential losses resulting from a fall in prevailing interest rates of the relevant bond in the market. This is made possible by providing them the right to redeem the security before it matures. Such provision is more common in corporate bonds and loans than government or municipal bonds, which are usually noncallable.

When a make-whole call provision is in effect, the issuer must pay the bondholder or lender a sum that reflects the present value of the remaining future cash flows that the bondholder would have received if the bonds were held until their maturity date. This payment compensates the bondholder for any loss of income they may experience due to early redemption. On the other hand, from the issuer's perspective, the make-whole call provision might result in a higher cost of refinancing or calling the bonds before maturity, particularly if interest rates have declined since the issuance of the bonds.

There can be multiple reasons for exercising this provision, such as escaping the risks arising from contractual violations, increasing cash reserves, availing oneself of relatively lucrative debt financing options, or initiating capital restructuring. The make-whole call provision process involves triggering or exercising the call option after the call protection period, if any. It requires evaluating the make-whole call amount at the discounted value of future payments.

Such payments include the principal amount, unpaid coupons, and accrued interest payments. Also, its calculation is based on the sum of the discounted rate of an equivalent bond yield and the make-whole call spread. This rate is multiplied by the outstanding coupon payment and the principal amount to arrive at the make-whole call premium figure. This payment ensures bondholders receive compensation for the lost interest income they would have earned if the bonds were held until maturity.

Examples

Here are a few examples to facilitate further discussion. 

Example #1

Assume a bond has a face value of $1000 and an annual coupon rate of 4%. It is set to mature after six years from now. Its current price is $1067. If the bond has a make-whole call provision and the issuer exercises it at present, the make-whole spread will be +40bp. Now, a reference treasury that will mature around the same time offers a 1.89% current yield. Thus, the make-whole call premium will be 1.89 + 0.4 = 2.29%. Hence, the make-whole call amount will be $1204.4 (2.29% of $1000 for six years + $1000 face value). In this way, a decision can be made about exercising this provision.

Example #2

Many multinationals and other corporate entities offer such bonds to enable people to invest in varied financial instruments. Dell Inc., a reputable name in the IT sector, issued corporate unsecured bonds with the make-whole call provision. The coupon rate is 7.10%, and it falls due on April 15, 2028. Depending on the options issuers have in terms of boosting their earnings, they may decide to hold or avail themselves of this provision.

Advantages and Disadvantages

Although such call provisions are not exercised frequently, they offer a few benefits, as discussed below:

1. Compensates Debtor for Premature Redemption: Make-whole call provisions allow investors to receive bond premiums based on the Net Present Value (NPV) of the coupon payments to offset the loss of future interest income.
2. Higher Return: Bondholders receive higher than ordinary returns under make-whole call premiums when the issuer invokes this call provision.
3. Enhanced Flexibility for Issuers: It offers issuers greater flexibility in managing their debt obligations. If interest rates decrease after the bond issuance, the issuer can take advantage of lower rates by redeeming the bonds early and refinancing at more favorable terms.
4. Lower Borrowing Costs: Financial instruments with such a provision attract more investors, enabling issuers to secure funding at more competitive interest rates.
5. Mitigates Reinvestment Risk for Investors: Investors who purchase bonds with such provisions are partially protected against interest rate risk. If interest rates rise significantly, the issuer is less likely to call the bonds early, and investors can continue to receive higher interest payments until maturity.
6. Transparency and Predictability: It provides transparent and predictable guidelines for early redemption. The predetermined formula for calculating the redemption payment ensures transparency and eliminates ambiguity.

However, such a call provision also has certain limitations:

1. Rarely Exercised: Since it burdens the issuer with a high premature redemption cost, such provisions are only sometimes executed.
2. Potential Loss to Investors: Early redemption through such a call provision may lead to a potential loss of interest income since the redemption payment may not fully compensate investors for the lost future interest income.
3. Lacks Stability: Investors might hesitate to commit to long-term investments with make-whole call provisions as they are unsure of its redemption.
4. Complexity: Computing redemption payment can be complicated, and investors may require professional assistance to assess potential risks and rewards before investing in such securities.
5. Redemption Risk: The issuer's decision to redeem the bonds early could be sudden and is influenced by various factors investors may find difficult to interpret.

Make-Whole Call Provision vs Traditional Call vs Callable Bond

The make-whole call provision, traditional call, and callable bond are the three different kinds of fixed-income security provisions that extend the right of premature redemption or retirement of the security.

Investors and debtors need to be aware of the following significant differences between the three before investing in bonds and other debt securities:

Basis	Make-Whole Call Provision	Traditional Call	Callable Bond
Definition	A make-whole call provision is a specific indenture term that states the issuer's right but not the obligation to redeem the bond early while compensating the bondholders for premature retirement.	A traditional call provision is a feature in bonds that allows the issuer to retire the bond before its maturity date by paying a specified call price, usually higher than the bond's face value.	A callable bond is a fixed-income security whose issuer has the right to redeem it before its maturity date, subject to certain conditions, such as paying a premium (the call price) to bondholders.
Purpose	It protects bondholders from losing potential interest income in a declining interest rate environment.	It offers issuers the flexibility to redeem the bond early, thereby reducing their interest expenses if interest rates have declined since the bond's issuance.	It allows issuers to reduce the debt cost by redeeming the bond early and re-borrowing the funds by issuing these bonds at a lower interest rate.
Call Price	It has a moving target call price, which can always be set at the bond's par value.	The call price is predetermined or fixed and is more than the face value of a bond.	Total face value at a specified or fixed price is considered.
Exercise Time	It can be exercised anytime during the bond's time to maturity.	It can be exercised after a predetermined period lapses.	It can be exercised after the call protection period concludes.
Risk	Low	Moderate	High
Common in	Corporate bonds and loans are examples of this provision.	Government and municipal bonds are examples of such bonds.	Municipal bonds issued to finance government and public welfare projects are examples of such bonds.
Protects	Investors, debtors, and bondholders	Issuers	Issuers
Calculation	The make-whole call amount is evaluated as the Net Present Value (NPV) of the remaining cash flows on the bond, discounted at a pre-specified rate (often a benchmark rate like the treasury rate) plus a premium.	The call price is evaluated by adding the premium amount to the bond's face value.	Price of Callable Bond = Conventional Vanilla / Noncallable Bond Price – Call Option Price

Frequently Asked Questions (FAQs)

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