What is the provisional call function?
A tentative call feature allows an issuer, typically of convertibles, to redeem (call back) the issue for a non-call period if certain criteria, such as a price threshold, are met.
The normal buying characteristics found in callable bonds can generally only be exercised after a set period, such as 10 years after issuance.
- A tentative calling feature enables a security issuer to cancel the issue early, even outside the normal calling window, if a threshold is crossed.
- The interim calling feature protects the issuer from being forced to convert at an unfavorable price.
- Typically, the terms of a tentative call are 150 percent of the conversion price for 20 consecutive days.
Understanding Temporary Calling Features
The provisional call option function gives the issuer the right to accelerate the first redemption date if the underlying common shares trade at or above a predetermined level for an extended period. Its objective is to protect an issuer from being forced to honor the conversion, for example, of a convertible bond into ordinary shares, at an unfavorable price.
For example, a convertible bond may allow a provisional call on the issue if the underlying common shares are trading at 120 percent of the conversion price for 30 consecutive days. This percentage, or multiple, of the conversion price is known as the trigger price, because it triggers the conversion. Typically, the terms of a tentative call are 150 percent of the conversion price for 20 consecutive days.
Call protection is important to investors because it guarantees the optionality of the convertible, along with any return advantage it may have on the underlying stocks for a fixed period of time. Typically, the longer the call protection duration, the greater the benefit to investors.
There are two types of call protection: hard call provision and soft call provision. Most convertible bonds are issued with a hard call provision, which protects bondholders from having their bonds canceled before a certain time has elapsed. During the hard call protection period, a bond cannot be requested under any circumstances. Convertible bonds may carry an interim soft call feature in addition to or instead of hard call protection. The provisional soft call protection is when the bonds can be canceled subject to the price of the underlying common shares being above a certain level.
Pros and cons of a provisional call function
Investors should carefully consider the advantages and disadvantages of a security call feature before investing:
- Cons: A buy function creates uncertainty about whether or not a bond will remain pending until its maturity date is reached. Investors risk losing a bond that pays a higher interest rate when rates drop and issuers reclaim their bonds. When this occurs, investors generally have to reinvest in securities that have lower returns. Additionally, options will generally limit the appreciation of the price of a bond that would otherwise be expected to rise when interest rates begin to decline.
- Pros: Bonds with a buy function generally put investors at a disadvantage. Therefore, callable bonds offer higher returns than non-callable ones. However, higher returns by themselves are not always attractive enough to convince investors to buy them. Therefore, to make bonds more attractive, issuers often set the purchase price of the bond above the face value, or principal, of the issue. This difference between the purchase price and the principal is the purchase premium.