When you buy a bond, the purchase is fueled by the attractive yield it pays. If interest rates drop, you want to keep the bond and keep earning the yield for as long as possible. The issuer, on the other hand, would be happy to redeem the bond and issue new bonds at a lower rate. If a bond is callable, the issuer can do just that -- call in and pay off your high yield bond. Hard and soft call protection limits the issuer's ability to call in bonds.
Function of Bonds
Investment bonds are typically issued with fixed interest rate payments and a set maturity date. For example, a corporation issues a 12-year bond paying a 6 percent interest rate. An investor who buys $100,000 of the bond will receive $6,000 per year and the $100,000 back when the bond matures in 12 years. The company is obligated to make those payments. To give themselves some flexibility, bond issuers often include call provisions with newly issued bonds. The call provisions allow an issuer to call in bonds and pay them off early.
Hard Call Protection
A call provision on a bond may be a specific date after which the company can call bonds, requiring investors to turn them in for the face amount or the face amount plus a premium. For example, a 12-year bond issue may be callable after five years. The five years until a bond can be called is known as hard call protection. Investors know they will earn the interest paid by the bond until at least the first call date. When bonds are purchased, the broker will usually provide the yield-to-call as well as the yield-to-maturity to show an accurate assessment of the investment potential.
Soft Call Protection
If a bond issue has soft call protection, that provision of the bond goes into effect after the hard call protection has passed. Soft call protection is usually a premium to par -- a value higher than the face or maturity value -- that the issuer must pay to call in the bonds before maturity. For example, when the first call date is reached, the issuer may have to pay a 3 percent premium to call the bonds for the next year, a 2 percent premium the following year and a 1 percent premium if the bonds are called more than two years after the hard call expires. Soft call protection does not stop a bond from being called in, but it does pay the investor a premium to the face value.
When investing in bonds with call options, pay attention to when the hard call protection expires and the terms of any soft call. The hard call protection starts when the bonds were issued, and if you are buying bonds in the secondary market, little time may be left before the call protection expires. That longer term bond with a great yield may not be such an attractive investment if it can be called in by the issuer in a year or two. Your broker should explain all of the call features of a potential bond investment and what will happen if the bond is called.