What is a catastrophe call?
A catastrophe call is a call provision in municipal bonds that allows early redemption of the instrument if a catastrophic event occurs and severely damages the project financed by the issue. Potential catastrophes will be listed in the bond issue contract and will often be paid at par.
It is a type of extraordinary rescue provision that is used to make up for the loss of income from a municipal bond that was issued to finance the construction of a community facility that later suffers significant damage, limiting its ability to generate income to pay the bond. .
These should not be confused with a calamity call, which is a protective measure for investors in a secured mortgage obligation (CMO) that is triggered if defaults or early payments on the underlying mortgages threaten to disrupt the cash flow generated by the investment.
- A catastrophe call allows early redemption of a debt instrument if a catastrophic event occurs that causes damage to the project being financed.
- These are most often associated with municipal bonds.
- Catastrophe provisions generally have a higher yield than general obligation bonds, as the issuer has a higher risk burden.
- Catastrophe calling provisions are more common on income bonds than on GO bonds.
Understanding the call of catastrophe
Catastrophe calls provide municipalities with insurance against natural disasters. For example, let’s say an earthquake destroyed a newly built bridge. Since the cost of construction was financed by a municipal bond issue (with a catastrophe purchase option) and the destruction of the bridge does not allow it to generate the revenues that are expected to pay the debt, the bonds can be called at par immediately. Since catastrophe-provisioned bonds carry a higher risk burden for the issuer, they generally also have a higher yield than general obligation (GO) bonds to account for risk factor.
It is not advantageous for all municipal bonds to issue a catastrophe call provision, but catastrophe call provisions are more common on revenue bonds. Revenue bonds are a specific type of municipal bond that is issued to finance specific projects that, in turn, will produce their own income. The idea is that by issuing these types of bonds, the project’s income stream will return the bond. Additionally, income bondholders generally do not have a financial claim on the assets of the completed project.
For example, an institution that issued a revenue bond for a toll road cannot regain ownership of the toll road if it does not produce the expected and agreed-upon revenue to pay the interest and principal.
Catastrophe call example
Consider the following scenario: The City of Pleasantville wants to build a new toll road because of its position as a major transit road for commuters during the summer months. However, the City of Pleasantville does not have the funds to build the toll road.
To finance the construction of the highway, the municipality issues revenue bonds to its residents for the generation of funds, with the plan that the tolls collected then pay the payments and interest on the bonds within 30 years, as established in the bond contract. . Because the city of Pleasantville is also located near a fault, the revenue bonds contain a catastrophe call provision, which investors are aware of.
Three years after the project is funded and the toll roads are built, an earthquake hits the city of Pleasantville and the toll roads are affected by the natural disaster. The earthquake qualifies under the catastrophic call provision, which means that the City of Pleasantville is eligible to cancel its bonds. Calling the bonds allows the city to pay off the bonds immediately rather than waiting for the original life of the bond, subsequently avoiding any remaining portion of the bond’s interest earnings.