When a company or other entity issues a bond, it sometimes likes to have an escape plan to get out of its commitment. A deferred call provision gives a bond issuer the right to call -- or buy back -- its bonds after an initial deferment period, which might last five, 10 or some other number of years. Before you toss one of these types of bonds into your portfolio, review some of its advantages and disadvantages to see if it’s a good fit.
Higher Interest Rate
Investors prefer to decide for themselves when to sell an investment. Because you might have to retire a bond with a deferred call provision earlier than you want to, this type of bond typically pays a higher interest rate than one without this provision. You reap the benefit of higher interest income. For example, a bond with a deferred call provision might pay a 7 percent interest rate while one without this provision might pay only 6 percent.
When you own a bond with a deferred call provision, you’re protected from having to sell during the deferment period. Brokers provide information on how long a bond’s deferment period is, the date when the issuer is first able to call the bond and other relevant details. Since you have this info beforehand, you have the advantage of knowing exactly how much interest you’ll earn during this period and can plan ahead to avoid surprises.
A bond with a deferred call provision has a predetermined call price that a company must pay a bondholder to extinguish the bond. Because investors in the market know this, you likely won’t be able to sell the bond for more than this price. For example, say interest rates decline, pushing your bond’s estimated value to $1,150. If the bond’s call price is $1,100, the market price will likely remain less than $1,100, and you’ll lose out on the additional value.
Lower Reinvestment Rate
A company typically calls a bond when market interest rates are lower than the rate it pays on the bond. It issues new bonds at the lower rate and no longer pays you the higher rate. Unfortunately, if you want to replace your old bonds with similar ones, you’re stuck reinvesting at the lower market rate. For example, if you own a bond that pays 6 percent interest and rates fall to 5 percent, your bond might be called, forcing you to reinvest at 5 percent.