Debt Overhang and the Life Cycle of Callable Bonds

Abstract

We show that callable bonds have both higher yields and lower market prices than non-callable bonds of the same issuer, reflecting the value of call features to issuers and investors. This cost of and both the inclusion and the exercise of call rights are determined by levels and changes in issuer-specific credit quality. Our agency-based theoretical and empirical analyses further demonstrate that callability reduces debt overhang in corporate mergers and investment. Our results help explain the value and prevalence of callable bonds. They suggest that debt callability is a key capital structure parameter.