If you have developed an interest in straight and convertible bond investing, you will soon run across what's referred to as hard and soft call protection. The ability to call a bond provides flexibility to the bond issuer -- usually to the detriment of the investors who bought the bond. Call protection puts some limits on when and how a bond can be called.
Called in Bond
When a company issues a bond, its purpose is to borrow money for a fixed period of time. A bond typically pays a fixed rate of interest each year and the principal value on maturity. If a bond is callable, the issuer can call the bond back before the maturity date, paying the principal amount or the principal plus a percentage bonus. When a bond is called, the investors no longer will receive any of the interest payments that would have come in after the call date. A bond issuer usually calls a bond if the bond pays a high rate of interest and new bonds could be issued at a lower rate. This is good for the bond issuer, but bad for the investors earning that high interest rate.
Hard Call Protection
Hard call protection exists if a bond cannot be called before a certain date. For example, you might purchase a 10-year corporate bond, and the first time the issuer can call the bond is at the 5-year point. With the hard call date, an investor knows that she will earn the bond's stated interest at least until that date. When comparing the investment prospects of a bond, both the yield to maturity and the yield to call are calculated. Investment decisions should be made on the lower of the two yields -- usually the yield to the hard call date.
Soft call protection requires the bond issuer to pay a premium to the bond's principal value if the bond is called in early. As an example, to call a hypothetical bond issue early, the issuer is required to pay 103 percent of the principal amount. The soft call premium of an extra 3 percent is there to discourage the issuer from calling the bond. However, the soft bond protection does not stop the issuer if the company really wants to call in the bond.
Types of Securities
Hard or soft call protection can be applied to any type of commercial lender/borrower arrangement. Convertible bonds -- which can be exchange for a certain number of the issuer's common shares -- often have one or both types of call protection to make them more attractive to investors. Commercial loans can include soft call provisions to prevent the borrower from refinancing when interest rates decline.
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