Advantages and Disadvantages of a Deferred Call Provision

Bond issuers are sometimes motivated to retire a bond before its final maturity date. For instance, if interest rates decline, a bond issuer can save money by buying back existing bonds and issuing new ones at a lower interest rate. To facilitate bond retirement, issuers may incorporate a call provision that allows the issuer to redeem a bond for a preset price – the call price. A deferred call provision is one in which a call cannot be executed until the deferral date, which is usually several years after the bond issue date.

Certainty of Payments

A bond investor who requires a period of payment certainty will favor a call schedule that is deferred, because cash flows will continue until at least the deferral date. It may be that the investor has earmarked the cash flow from a bond for a certain purpose that extends to the deferral date but not necessarily to the maturity date. A bond with a suitable deferred call provision is an excellent fit for such an investor.

Financial Planning

A bond issuer usually seeks stability and certainty when it takes on financial obligations. By creating a period in which a call cannot be executed, the issuer knows it must be able to fund the bond payments for a certain amount of time. It thus is obliged to make suitable financial arrangements that ensure the payment of bond principal and interest until the deferral date. Once the deferral date arrives, the issuer can choose whether or not to execute its call option, giving it added flexibility it may require to maintain its financial stability.

Lack of Short-Term Flexibility

Some bond issuers operate in volatile markets or sectors and may feel disadvantaged by lacking the ability to retire a bond issue before the deferral date. In effect, the issuer is locked into several years of bond payments even if circumstances radically change. This disadvantage is somewhat mitigated if the issuer can afford to buy back the bonds in the secondary market before the deferral date at then-current market prices. If market prices are above the call price, this strategy will require more money, another disadvantage.

Reduced Income for Investors

A call option on a bond is a valuable thing for the issuer, which the issuer must pay for by offering a higher bond yield relative to the yield on a non-callable bond. This is good for investors who don’t mind having their bonds called in return for higher yield, but bad for the issuer who must pay more interest. A deferred call provision lowers the value of the call option, thereby reducing the extra yield that would be collected by investors if the deferral was omitted.

Resources (2)

  • Bonds: An Introduction to the Core Concepts; Mark Mobius
  • Bonds: The Unbeaten Path to Secure Investment Growth; Hildy Richelson, Stan Richelson

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