Make Whole Call Provision
A make-whole call provision is a type of call provision on a bond allowing the issuer to pay off remaining debt early. The issuer typically has to make a lump-sum payment to the investor. The payment is derived from a formula based on the net present value (NPV) of previously scheduled coupon payments and the principal that the investor would have received.
Definition: A make-whole call provision is a call provision in a bond that allows the issuer to repay the remaining debt early. The issuer typically needs to make a one-time payment to investors. This payment is determined based on a formula that calculates the net present value (NPV) of the previously scheduled interest payments and the principal that investors would have received.
Origin: The concept of make-whole call provisions originated in the development of the bond market, particularly in the mid-20th century when corporations and governments began widely issuing bonds to raise funds. To increase the flexibility and attractiveness of bonds, issuers introduced various provisions, including make-whole call provisions, to allow for early repayment of high-interest debt when market interest rates decline.
Categories and Characteristics: Make-whole call provisions can be categorized into two main types: callable bonds and non-callable bonds.
- Callable Bonds: These bonds allow the issuer to repay the debt early under specific conditions, usually requiring a premium payment. They are characterized by high flexibility but pose reinvestment risk to investors.
- Non-Callable Bonds: These bonds do not allow for early repayment, providing investors with stable interest income but limiting the issuer's flexibility.
Specific Cases:
- Case One: A company issued a batch of 10-year bonds with a coupon rate of 6% when market interest rates were high. Three years later, market interest rates dropped to 4%, and the company decided to exercise the make-whole call provision to repay the debt early, making a one-time payment to investors calculated based on the NPV formula.
- Case Two: A government issued a batch of 20-year infrastructure bonds with a coupon rate of 5%. Five years later, market interest rates dropped to 3%, and the government decided to repay the debt early, making a one-time payment to investors calculated based on the NPV formula to reduce interest expenses.
Common Questions:
- Will investors lose income due to early repayment? Yes, investors may face reinvestment risk as they need to reinvest at lower market interest rates.
- Why do issuers want to repay debt early? The main reason is the decline in market interest rates, allowing issuers to reduce interest expenses by repaying high-interest debt and reissuing low-interest debt.
