Make-whole Call Provision

Brackenhall Chemical's 20-year debentures may be redeemed at any time at the issuer's option at the GREATER of par or the present value of all remaining scheduled interest and principal payments, discounted at the yield of a comparable Treasury issue plus 25 basis points. Portfolio manager Devi Ramakrishnan asks what this provision means for her position. The best answer is:

1. A.It is a sinking fund provision requiring Brackenhall to retire a stated portion of the issue each year.Incorrect. A sinking fund mandates scheduled retirement of a portion of the issue, usually by lot or open market purchase. Nothing here is scheduled or mandatory.
2. B.It is a put provision allowing Devi to sell the bonds back to the issuer at the make-whole price.Incorrect. The option belongs to the ISSUER ("at the issuer's option"). A put would give the holder the right to require redemption.
3. C.It is a make-whole call: because the redemption price rises as yields fall, calling is rarely economic for the issuer, so the bond behaves much more like a noncallable bond than one with a fixed call price.Correct. Discounting remaining cash flows at a Treasury yield plus a narrow spread makes the call price float upward with the bond's value, which removes most of the issuer's incentive to call and preserves the holder's upside.
4. D.It caps her price appreciation at par if rates fall, exactly as a traditional call at 100 would.Incorrect. That is the effect of a FIXED-price call. Under a make-whole formula the call price itself rises when rates fall, so appreciation is not capped at par.

Why: This is a make-whole call provision. Instead of a fixed call price, the redemption price is computed by discounting the bond's remaining cash flows at a narrow spread over Treasuries. When market yields fall, that present value rises, so the price the issuer must pay to call rises right along with the bond's value. The issuer is therefore "making the holder whole" and almost never gains by calling. Practically, the bond trades and behaves much like a noncallable bond: the holder keeps most of the price appreciation when rates decline and does not suffer the negative convexity of a traditional fixed-price call.

A corporate bond held by Ignatz Halloway-Ruiz carries a make-whole call provision. Interest rates fall sharply and the issuer decides to redeem the bond early. Compared with a traditional fixed-price call, the make-whole call means that:

1. A.The redemption price rises as rates fall, largely compensating him for the interest stream he losesCorrect. Discounting the remaining cash flows at a small spread over Treasuries makes the call price rise as rates decline.
2. B.He receives par, exactly as he would under a traditional fixed-price callThe make-whole formula pays the greater of par or the present value, which exceeds par when rates fall.
3. C.He receives a fixed call price set at issuance regardless of the level of ratesThat describes a traditional call; a make-whole price floats with the reference Treasury yield.
4. D.The issuer may redeem without paying accrued interest through the redemption dateAccrued interest is always paid, and the make-whole formula values the remaining stream as well.

Why: A make-whole call requires the issuer to redeem at the greater of par or the present value of the bond's remaining principal and interest, discounted at a reference Treasury yield plus a small spread. Because the discount rate is only slightly above Treasuries, the redemption price rises as rates fall, so the holder is substantially compensated for the lost stream. This makes make-whole calls expensive for issuers and rarely exercised, and it means holders bear far less call and reinvestment risk than under a traditional fixed-price call.