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Outline how a corporate bond may be retired before it matures.

FRM® Part I · Financial Markets and Products · Corporate Bonds · FRM1.FM.17.g

The idea

A corporate bond may be retired before maturity in several ways. A call provision lets the issuer redeem at a stated call price, often after a call-protection period. A make-whole call instead sets the price at the present value of the remaining cash flows, discounted at a Treasury yield plus a small spread, so it is costly for the issuer to exercise. A sinking fund requires the issuer to retire part of the issue on a schedule. The issuer can buy bonds in the open market, which is cheaper when the price is below par, or call them at par by lottery, which is cheaper when the price is above par. A tender offer or open-market repurchase can also retire bonds, and some bonds are redeemed early with asset-sale proceeds. Calls benefit the issuer, so investors face reinvestment risk and price compression.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does a callable corporate bond give the issuer?

  1. The right to require holders to sell the bond back at par.Why not: Describes a put, which favours the holder.
  2. The obligation to retire a part of the issue each year.Why not: Describes a sinking fund obligation.
  3. The right to redeem the bond early at a set price. - correct
  4. The right to convert the bond into shares.Why not: Describes a convertible feature.

A call provision lets the issuer retire the bond early at a stated price, typically when rates fall, and the holder is exposed to reinvestment and price-compression risk.

A harder one

A callable corporate bond has a 5% annual coupon and three years to maturity (face 100). It carries a make-whole call: the call price equals the present value of the remaining cash flows discounted at the Treasury yield of 3.0% plus a 50 bp spread. A fixed-price call at 102 is not available. What is the make-whole call price?

  1. 105.66Why not: Discounts at the Treasury yield only, omitting the 50 bp make-whole spread.
  2. 102.00Why not: Uses a fixed call price; the make-whole price is computed from the discounted remaining cash flows.
  3. 100.00Why not: Discounts at the coupon rate and returns par.
  4. 104.20 - correct

Discount the 5, 5 and 105 cash flows at 3.5%: 104.20. A make-whole call price moves up when Treasury yields fall, so exercising is costly for the issuer.

The hardest tier

A bond with face 100, a 7% annual coupon and 8 years to maturity trades at 108. It is callable in 4 years at 102. Which statement gives the yield to worst correctly (annual compounding)?

  1. 5.20%, which is the yield to call, as it is lower than the yield to maturity of 5.73%. - correct
  2. 5.73%, which is the yield to maturity, as the call is not exercised until later.Why not: Defaults to yield to maturity, but the premium bond is most likely to be called when YTC is lower.
  3. 6.48%, which is the current yield.Why not: Reports the current yield (coupon / price), which is not a yield to worst.
  4. 5.46%, the average of the yield to maturity and the yield to call.Why not: Averages the two yields; yield to worst is the lower of the two, not an average.

YTM over 8 years = 5.73%; YTC at 102 in 4 years = 5.20%. Yield to worst is the lowest, 5.20%. For premium bonds, the call usually gives the lowest yield.

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