This is a summary of “The Make-Whole and Canada-Call Provisions,” by Zvika Afik, Gady Jacoby, David Strangeland, and Zhenyu Wu, published in the Journal of International Financial Markets, Institutions & Money, vol. 61.
The authors discuss material considerations that could make issuers’ exercise of the make-whole call provision in bonds beneficial, even though the option is out of the money based on the prevailing interest rate scenario.
What Is the Investment Issue?
Make-whole call provisions in bonds are widely prevalent in North America. The authors demonstrate the possible benefits and optimal exercise of make-whole call provisions for issuers, even when the option is seemingly out of the money.
How Did the Authors Conduct This Research?
The authors base their discussion on the standard equation Y = R + YS, where Y is the yield of the bond and R is the equivalent Treasury yield of the same maturity. They demonstrate that the make-whole call option can be in the money only for premium bonds in a declining interest rate scenario. For discount or par bonds, the net present value of calling the bond cannot be positive, and it will thus never be financially beneficial to call the bond. Furthermore, even for premium bonds, calling a make-whole bond is beneficial financially only when YS < MWS, where MWS is the make-whole spread.
Interest rate hedging may not be the only incentive for issuing callable bonds:
“there are other benefits from retiring a bond issue, such as allowing for a value-adding restructuring/recapitalization or the avoidance of a troublesome covenant, then, relative to a tender offer, exercising a make-whole call may be optimal.”
What Are the Findings and Implications for Investors and Investment Professionals?
The authors’ findings would be useful for company managers assessing the cost–benefit trade-off of additional features of a prospective bond in terms of their expectations of the future growth and direction of the company. Using the call option of a make-whole call bond is considered cost effective for the company compared with retiring the bond through a tender offer.
Investment professionals interested in the likelihood of a maximum yield on investment, price behavior, the possible investment horizon at the time of investment decision, and so forth would also find these findings relevant. These considerations can be material when weighing the pros and cons of adding an investment or rebalancing a portfolio.
The authors’ research is pertinent in the landscape of financial innovation taking place in fixed income.