Make-whole calls (MWC) first appeared in the bond markets in the mid 1990s and have become commonplace ever since. In fact, MWCs have become more commonplace in corporate bonds than their counterpart the traditional par call. Although this type of call option is infrequently exercised by the issuer, it may provide significant advantages to the bondholder, as well as to the issuer.
At the most basic level a MWC, when exercised by the issuer, provides an investor with a redemption price that is the greater of the following:
- Par value, or
- A price that corresponds to the specific yield spread over a stated benchmark such as a comparable Treasury security (plus accrued interest)
A make-whole call provides a form of protection, as implied by the name, because it requires the investor to at least, “be made whole” (par value) and can be viewed as a form of downside protection.
Difference between a MWC and a Traditional Call:
MWCs are quoted in a spread to a predetermined Treasury security with a similar maturity; for example a 10-year corporate bond would likely be matched to a 10-year Treasury. This differs from a traditional call option that has its call price either fixed or predetermined according to a call schedule. Whereas a traditional call can only occur after a specified period of time, it should be noted that a MWC can be exercised at any time. Additionally, as the spread between the MWC bond and its benchmark Treasury narrows, the MWC price can continue to rise without a ceiling. Bonds that have a traditional call effectively have a price limit, or ceiling, as investors will be unlikely to purchase a bond for more than its call price once the call date draws near.
An Example of a Make-whole Call:
As mentioned earlier, the premium price is generally expressed as a spread which is a fixed number of basis points (100bp = 1%, or 1bp = .01%) over the yield on a comparable Treasury security (T). In this example, we will use a three- year Treasury note as a reference security. For example, a spread of T+100 bp would be the yield on the 3-year Treasury plus 1.00%. Let’s assume that a 1.40% coupon bond is trading at par (100), or $1,000 per bond. This would equate to a yield that is equal to a 100 bp spread over the three-year Treasury note, which yields 0.40% (140 bp – 40 bp = 100 bp). For our example we will also assume that this bond has a stated make-whole call spread of T+15 bp, and at this level, the callable price of the bond would be $1,025 per bond. With a Make-whole call option, the call price is based on the Treasury yield at the time the call occurs, and, therefore, cannot be predicted. Keep in mind, the call price is the greater of par or the price calculated using the make-whole-call premium.
Summary of a Make-Whole Call:
|Item||Make-whole Call||Traditional Call|
|Call Price||The call price will change as Treasury yield change. As the spread narrows the price will increase. Conversely, as the spread widens the price will decrease. The call price will never be below par.
The call price will never be below par.
|Call price is fixed|
|When can I Be Called?||Callable anytime, although usually during a restricting period such as a merger, takeover, etc.||Predetermined according to a schedule.|
|Is this Common?||Many corporate bonds, some municipal bonds and preferred securities have MWC provisions.||Some bonds have both traditional and MWCs together.|
There are risks involved with this strategy including, but not limited to, changes in interest rates, liquidity, credit quality, volatility and duration. Past performance is no assurance of future results. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor.