Callable Bonds and Hedging

Abstract

We provide evidence that Þrms attach call options to debt issues to manage interest rate risk. We show, using extensive time series data on these hedging transactions, that the hedging decision is explained remarkably well by theories of hedging demand, such as the bankruptcy and underinvestment explanations for why Þrms hedge. Our setting also leads to new and unique evidence on the importance of the supply side in determining Þrms’ hedging strategies. Consistent with this idea, we document that Þrst time issuers in bond markets and small Þrms are more likely to hedge using call options in bonds, contrary to virtually all received evidence that large Þrms are more likely to hedge. The role of the supply side in hedging is further underlined by our evidence of a secular and robust shift away from calls in the 1990s, a period of rapid growth and increased availability of OTC derivatives. Every firm that issues fixed rate debt must decide whether to attach a call option to the debt issue. The call option gives the issuer the right to call the bond at a fixed strike price any time before bond maturity, after an initial “protection” period. The option helps issuers hedge against declining interest rates, by allowing them to call the bond if interest rates drop and replace it with lower-cost debt. While some issuers attach call options to their debt issues, others do not. In this paper, we examine the determinants of this choice between callable and non-callable debt over a long time series of debt issues between 1981 and 1997, using an extensive set of explanatory variables that includes firm characteristics, issue characteristics, and market conditions. Our analysis contributes to two strands of literature. First, we add to the early empirical literature on why firms attach call options to their bond issues (Thatcher (1985), Mitchell (1991), Kish and Livingston (1992), Crabbe and Helwege (1994)). Our evidence consolidates the fragmented results reported in this literature, and provides findings consistent with a hedging explanation for attaching call options to bonds. The hedging explanation finds surprisingly weak support in previous studies, which report that interest rates are often weakly significant, insignificant, or even negatively related to call usage. In contrast, we show that call usage is positively and significantly related to multiple proxies for the incremental interest rate risk from debt issues, such as issue size, maturity and the level of interest rates. These results resolve an empirical puzzle recently reported by Crabbe and Helwege (1994) that none of the received security design theories underinvestment, overinvestment, and signaling (Barnea, Haugen, and Senbet (1980), Robbins and Schatzberg (1986), Schwartz and Venezia (1994)) explain why firms issue callable bonds. Our evidence suggests that risk management concerns of firms explain the callable/non-callable bond choice. As Kraus (1983) writes, the interest-rate hedging explanation for issuing callable debt “has received little, if any, attention in the finance literature, [but] it offers another clue to the