Call Provision

Q: A municipality issued 20-year general obligation bonds five years ago with a 6% coupon rate, callable after 10 years at 103 (103% of par). Current market interest rates for similar bonds have fallen to 3.5%. The bonds are trading at $1,180. As the municipality's financial adviser, what recommendation would you most likely make regarding the call provision?

**B is correct.** The municipality should wait until the call protection period ends (year 10), then exercise the call provision and refinance at the lower 3.5% rate. This would save significant interest expense: calling the $1,000 par bonds at $1,030 (103% of par) and reissuing at 3.5% saves 2.5% annually on the debt service (6% - 3.5% = 2.5%), far exceeding the one-time $30 call premium per bond. The bonds cannot be called before year 10 due to call protection. A is incorrect because the call protection period prevents calling before year 10; the bonds have only been outstanding for 5 years. C is incorrect because the market price ($1,180) is irrelevant to the call decision; issuers call at the predetermined call price ($1,030), not the market price. D demonstrates backwards logic; issuers call when rates FALL (to refinance at lower rates), not when rates rise above the coupon.

Q: In a callable bond, who has the right to initiate the early redemption of the bond before its maturity date?

**B is correct.** The bond ISSUER has the unilateral right to call (redeem) the bond before maturity under the terms specified in the call provision. This is the fundamental characteristic of a callable bond. The issuer exercises this right when it becomes economically advantageous, typically when interest rates have fallen and the issuer can refinance at a lower cost. A is incorrect; bondholders do not have the right to force early redemption in callable bonds (that would be a "puttable bond," which is a different feature). C is incorrect; call provisions are one-sided, benefiting the issuer, not both parties. D is incorrect; the bond trustee administers the bond agreement but doesn't make call decisions; the issuer controls the call decision based on its financial interests.

Q: An investor purchases a callable corporate bond at $1,080 (premium) with a $1,000 par value, 6% annual coupon, 15 years to maturity, and callable in 5 years at $1,040. When calculating yields, which statement is most accurate?

**B is correct.** For bonds purchased at a premium, yield to call (YTC) is LOWER than yield to maturity (YTM). The investor paid $1,080 but will receive only $1,040 if called in 5 years (capital loss of $40), compared to receiving $1,000 if held to maturity in 15 years (capital loss of $80). However, the $40 loss occurs much sooner (5 years vs. 15 years), which reduces the annualized return more significantly. Additionally, coupon income is collected for only 5 years instead of 15 years. Both factors result in a lower YTC compared to YTM for premium bonds. A is backwards; YTC is lower, not higher, for premium bonds. C is incorrect; YTC and YTM are only equal when a bond is purchased at par. D is incorrect; investors MUST consider YTC when evaluating callable bonds purchased at a premium because it represents the worst-case yield scenario. For premium bonds, YTC is the more conservative (lower) yield assumption and represents the yield if the bond is called.

Q: All of the following statements about bonds with call provisions are accurate **EXCEPT**

**B is correct (the EXCEPT answer).** Issuers call bonds when market interest rates have FALLEN below the bond's coupon rate, NOT risen above it. When rates fall, issuers can refinance by calling high-coupon bonds and reissuing new bonds at lower current rates, reducing their interest expense. Calling bonds when rates have risen would be economically irrational, as the issuer would have to refinance at higher rates. A is accurate: callable bonds must offer higher yields (typically 25-75 basis points more) than non-callable bonds to compensate investors for call risk, reinvestment risk, and the price ceiling created by the call price. B is accurate: call protection (often 5-10 years) prevents early calls, giving investors some certainty about the minimum income period. D is accurate: when bonds are called during low-rate environments, investors must reinvest their principal at the prevailing lower rates, losing their high-yielding investment. This reinvestment risk is a major disadvantage of callable bonds for investors.

Q: A corporation issued callable bonds five years ago with a 7.5% coupon, 20-year maturity, callable at 105 after 10 years. Current market interest rates for similar bonds are 4.2%. Which of the following statements are accurate? 1. The issuer will likely call these bonds when the call protection period ends 2. Bondholders will benefit from the call because they receive a call premium of $50 per bond 3. The bonds are likely trading at a discount to par value 4. If called, investors face reinvestment risk because current rates are lower than the 7.5% coupon

**B is correct.** Statements 1 and 4 are accurate. Statement 1 is TRUE: The issuer will very likely call these bonds when the 10-year call protection ends (5 years from now). Current rates (4.2%) are significantly lower than the bond's 7.5% coupon. The issuer can save 3.3% annually by calling these bonds at 105 ($1,050) and refinancing at 4.2%, which far exceeds the one-time 5% call premium cost. Statement 2 is FALSE: While bondholders DO receive a $50 call premium ($1,000 × 5% = $50), they do NOT benefit overall from the call. They lose a 7.5% income stream and must reinvest at only 4.2%, suffering a 3.3% annual income reduction going forward. The $50 premium provides minimal compensation for this permanent income loss. Statement 3 is FALSE: These bonds are almost certainly trading at a PREMIUM to par, not a discount. With a 7.5% coupon in a 4.2% rate environment, investors would pay well above par for this high-yielding bond. However, the price is capped near the call price of $1,050 because rational investors won't pay much more than the price at which the bonds will likely be redeemed. Statement 4 is TRUE: Investors face significant reinvestment risk. If the bonds are called at $1,050, investors receive their principal and premium but can only reinvest at current rates of 4.2%, losing the 7.5% coupon income. This is the primary risk of callable bonds in declining rate environments.

Investment Vehicles High Relevance

A feature in bond indentures granting the issuer the right to redeem (call) bonds before maturity, typically when interest rates decline. Includes a call premium (often a slight premium above par value) to compensate investors for early redemption. Call protection periods (usually 5-10 years) prevent calls during initial years. Callable bonds offer higher yields than non-callable bonds to compensate for reinvestment risk and price appreciation limits.

Example

A corporation issues 30-year bonds at par ($1,000) with a 7% coupon when rates are high. The bond has a call provision allowing redemption after 10 years at $1,070 (a 7% call premium above par). Five years later, interest rates drop to 4%. After the 10-year call protection period expires, the company exercises the call provision, redeeming bonds at $1,070. Investors receive their call premium but must reinvest at the new lower 4% rate, losing the 7% income stream.

Common Confusion

Students confuse who benefits from the call (issuer benefits when rates fall, not the investor), forget that callable bonds trade at lower prices than non-callable bonds (price ceiling at call price), don't understand the difference between call premium (compensation payment) and call protection (time period preventing calls), or miscalculate yield to call versus yield to maturity.

How This Is Tested

Determining when issuers are most likely to call bonds (when interest rates fall below the bond's coupon rate)
Comparing yield to call versus yield to maturity to identify which is lower for premium bonds
Identifying the risks investors face with callable bonds (reinvestment risk and limited price appreciation)
Calculating the call price given the par value and call premium (typically expressed as percentage above par)
Understanding that callable bonds must offer higher yields than non-callable bonds to attract investors

Regulatory Limits

Description	Limit	Notes
Typical call premium	Slight premium above par (varies by bond)	Call price typically 101-107% of par; often expressed as "callable at 103" meaning $1,030 per $1,000 bond
Call protection period	Typically 5-10 years	Period during which bonds cannot be called; varies by issuer and bond type

Example Exam Questions

Test your understanding with these practice questions. Select an answer to see the explanation.

Question 1

A municipality issued 20-year general obligation bonds five years ago with a 6% coupon rate, callable after 10 years at 103 (103% of par). Current market interest rates for similar bonds have fallen to 3.5%. The bonds are trading at $1,180. As the municipality's financial adviser, what recommendation would you most likely make regarding the call provision?

Question 2

In a callable bond, who has the right to initiate the early redemption of the bond before its maturity date?

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Question 3

An investor purchases a callable corporate bond at $1,080 (premium) with a $1,000 par value, 6% annual coupon, 15 years to maturity, and callable in 5 years at $1,040. When calculating yields, which statement is most accurate?

Question 4

All of the following statements about bonds with call provisions are accurate EXCEPT

Question 5

A corporation issued callable bonds five years ago with a 7.5% coupon, 20-year maturity, callable at 105 after 10 years. Current market interest rates for similar bonds are 4.2%. Which of the following statements are accurate?

1. The issuer will likely call these bonds when the call protection period ends
2. Bondholders will benefit from the call because they receive a call premium of $50 per bond
3. The bonds are likely trading at a discount to par value
4. If called, investors face reinvestment risk because current rates are lower than the 7.5% coupon

💡 Memory Aid

Think of a call provision like a landlord's early termination clause: The issuer (landlord) can kick you out, not the other way around. They call when "rates fall" (can refinance cheaper), leaving you to find a new home at worse terms (reinvestment risk). You get a going-away gift (call premium), but you lose your great deal. Call Protection = No-eviction period (typically 5-10 years). Remember: "Issuer calls when rates are CRAWLING down, investor loses their cash COW."