Why Callable Bonds Are not Called When the Market Price Reaches the Call Price: A Duration Argument

Samih Antoine Azar

doi:10.5539/ijbm.v11n1p90

Abstract

It is a fact that firms do not call callable bonds when bond prices reach for the first time the call price. This paper provides an original explanation for this behavior by resorting to duration analysis. It is known that, ceteris paribus, a bond with a higher coupon, or a higher yield, has a lower duration that a bond with a lower coupon, or a lower yield. This implies that the bond that is to be called has a lower duration than the bond that replaces it. A lower duration signifies a lower interest rate risk. The firm with a callable bond will wait for market interest rates to fall further in order to equalize durations and bear the same risk. The underlying assumption is that by equalizing durations the firm keeps facing the same financial risk. In this case, it is the same amount of interest rate risk. Consequently, there are no changes in the capital structure, no redistribution effects on other debt claims, and financial leverage is unaffected. The paper provides illustrations on this active law by considering four callable bonds, with different remaining maturities, and each one with a set of two different call prices.

Highlights

Callable bonds are not called when the market price of the callable bond reaches or first exceeds the call price. King and Mauer (2000, p. 412) find that “the average call delay is 27 (14) months for the overall sample, and over 86% of the calls are delayed.” Theoretically this is not an optimal policy and counts as a puzzle (Brennan & Schwartz, 1977; Ingersoll, 1977). Kraus (1983) and Mauer (1993) argue and prove that refunding and other transaction costs are recouped by calling and refinancing the bond at a lower rate if market interest rates fall further and fall enough
Longstaff and Tuckman (1994) study the importance of changes in capital structure. They show that firms, that carry more than one debt issue, avoid wealth redistribution to the remaining bondholders when the bond is called, and they end up delaying calling the bond, even if the change in capital structure is minor
This paper provides for an original argument on why firms, carrying a callable bond, delay redeeming this bond when the bond market price reaches for the first time the call price, preferring to wait until interest rates fall further

Summary

Introduction

Callable bonds are not called when the market price of the callable bond reaches or first exceeds the call price. King and Mauer (2000, p. 412) find that “the average (median) call delay is 27 (14) months for the overall sample, and over 86% of the calls are delayed.” Theoretically this is not an optimal policy and counts as a puzzle (Brennan & Schwartz, 1977; Ingersoll, 1977). Kraus (1983) and Mauer (1993) argue and prove that refunding and other transaction costs are recouped by calling and refinancing the bond at a lower rate if market interest rates fall further and fall enough. One interesting fact from this literature is that call provisions are appended and call option values are higher when interest rates are high and are variable In such cases a call feature is worthwhile if normal interest rates are considered to be lower and will tend to revert to this more normal level. In this regard the major assumption in this paper is that the firm will call and refinance immediately the bond or else will delay calling the bond. The rationale for delaying the call in this paper is not because of transaction and refunding costs like in Kraus (1983) or Mauer (1993), but because of changes in bond durations, and risk.

The Theoretical Framework

The Illustrations

Findings

Conclusion