Call Price

The call price is the price at which a bond or a preferred stock with a call feature can be redeemed by the issuer prior to its maturity date. It is also known as the redemption price.

Definition

A call price is the price at which a bond or a preferred stock with a call feature can be redeemed by the issuer before its maturity date. This price often includes a premium above the face value of the security, which compensates investors for the early termination of the investment. This premium is known as the call premium.

The call price is predetermined at the time of issuance and is specified in the bond or preferred stock’s indenture agreement or prospectus. Redemption at the call price allows the issuer to refinance the debt if interest rates decline or if the issuer’s credit standing improves, reducing the cost of capital.

Examples

  1. Corporate Bonds: Suppose a corporation issues a bond with a face value of $1,000 and a 5% annual coupon rate. The bond includes a call feature that allows the issuer to redeem the bond after five years at a call price of $1,050. If interest rates decrease after issuance, the issuer might choose to call the bond at the call price, repaying investors $1,050 per bond.

  2. Preferred Stock: Consider preferred stock with a $100 par value and a call feature, which allows the issuer to redeem the stock after three years at a call price of $105. If the issuer’s financial position improves, it may opt to redeem the preferred stock at the call price to issue new shares at a lower dividend rate.

Frequently Asked Questions

Q1: Why do issuers include a call feature in bonds or preferred stocks? A1: Issuers include a call feature to retain the flexibility to refinance the securities if interest rates fall or if their credit ratings improve, thereby lowering their borrowing costs.

Q2: How does the call price affect investors? A2: The call price can introduce reinvestment risk for investors, as they may need to reinvest the proceeds from a called bond or preferred stock at a lower interest rate or dividend yield. However, investors are compensated by the call premium.

Q3: What is the difference between a call price and a call premium? A3: The call price is the total amount paid by the issuer to redeem the bond or preferred stock, which includes the par value plus any call premium. The call premium is the extra amount above the par value paid to compensate investors for the early redemption.

Q4: Can the call price change over time? A4: Yes, the call price can be structured to decrease over time, according to a schedule specified in the bond or preferred stock’s indenture or prospectus.

Q5: Are there any drawbacks for issuers in calling a bond or preferred stock? A5: Calling a bond or preferred stock requires the issuer to have sufficient funds to cover the call price. Additionally, issuing new bonds or stocks may incur other costs.

  • Call Feature: A provision in a bond or preferred stock that allows the issuer to redeem the security before its maturity date.
  • Call Premium: The additional amount over the par value paid by the issuer when redeeming a bond or preferred stock with a call feature.
  • Indenture: A legal agreement between the bond issuer and bondholders outlining the terms and conditions of the bond, including any call features.
  • Reinvestment Risk: The risk faced by investors that they will need to reinvest the principal from a called bond or preferred stock at a lower rate of return.

Online References

Suggested Books for Further Studies

  • “Bond Markets, Analysis and Strategies” by Frank J. Fabozzi
  • “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
  • “The Handbook of Fixed Income Securities” by Frank J. Fabozzi and Steven V. Mann

Fundamentals of Call Price: Finance Basics Quiz

### What is a call price in relation to bonds and preferred stocks? - [x] The price at which they can be redeemed by the issuer before maturity. - [ ] The price at which they are sold in the open market. - [ ] The coupon rate of the bond. - [ ] The price at which they mature. > **Explanation:** The call price is the amount paid by the issuer to redeem the bond or preferred stock before its maturity date, often including the face value plus a call premium. ### Why would an issuer choose to call a bond? - [ ] To increase the interest rates. - [x] To refinance at a lower cost. - [ ] To double the principal. - [ ] To extend the maturity date. > **Explanation:** An issuer might call a bond to refinance the debt at a lower interest rate, reducing their borrowing costs. ### What is included in the call price besides the face value? - [ ] Coupon payments - [x] Call premium - [ ] Dividends - [ ] Interest payments > **Explanation:** The call price typically includes the face value and a call premium, which compensates investors for the early redemption of the bond or preferred stock. ### How does a call feature benefit the issuer? - [x] Provides flexibility to refinance when beneficial. - [ ] Increases the fixed costs. - [ ] Guarantees higher interest rates. - [ ] Extends bond maturity automatically. > **Explanation:** The call feature provides the issuer with the flexibility to refinance the securities if conditions are favorable, such as lower interest rates or improved credit standing. ### What introduces reinvestment risk for investors? - [ ] Maturity date extension - [ ] Rising interest rates - [ ] Higher interest payments - [x] Early redemption at the call price > **Explanation:** Early redemption at the call price can introduce reinvestment risk for investors, as they may have to reinvest at a lower rate of return. ### What document outlines the call features of a bond? - [x] Indenture - [ ] Prospectus - [ ] Investment portfolio - [ ] Shareholder agreement > **Explanation:** The indenture is the legal agreement that outlines the terms and conditions of a bond, including any call features. ### What compensation do investors receive for the early redemption? - [ ] Coupon payments - [ ] Lower rates - [x] Call premium - [ ] Dividends > **Explanation:** Investors receive a call premium, an extra amount over the face value, as compensation for the early redemption of the bond or preferred stock. ### Can the call price vary over time? - [x] Yes, according to a predetermined schedule. - [ ] No, it remains the same. - [ ] Only if the interest rates change. - [ ] Only in exceptional circumstances. > **Explanation:** The call price can change over time according to a schedule set forth in the bond or preferred stock agreement, typically decreasing as the security approaches its maturity date. ### What is another term for the call price? - [ ] Market price - [ ] Conversion price - [x] Redemption price - [ ] Purchase price > **Explanation:** The call price is also referred to as the redemption price, the amount paid to investors when the security is called before maturity. ### What factor is directly impacted when a bond is called? - [ ] Extension of investment period - [ ] Income stability - [ ] Capital gain - [x] Reinvestment opportunity > **Explanation:** When a bond is called, the investor’s potential reinvestment opportunities are directly impacted due to the need to find a new investment possibly at a lower return.

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Wednesday, August 7, 2024

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