Can someone please explain how make-whole call works? Why would an issuer issue a callable bond that would eventually penalize him/her? This doesn’t make sense. Also, I am unclear about the mechanics (calculations) of make-whole call bond. I’d appreciate help.
Instead of the call price being fixed (e.g., 104), the call price is determined by discounting the remaining payments to the call date. The discount rate used in calculating the call price is usually the current Treasury rate plus a fixed spread.
Suppose that a company issues a 10-year, 4% coupon, semiannual pay, $1,000 par bond, callable after 5 years, with a make-whole discount rate equal to the Treasury rate + 100bp. Five years after issuance, the bonds are selling at a YTM of 5%, and the 5-year Treasury rate is 2.5%. The market price of the bonds is $956.24, while the call price is $1,022.75.
Issuers do this to reduce the bondholders’ risk, allowing them to issue bonds with a lower coupon. (A better way to think of it is that they can issue the bonds at a lower YTM.)
Thanks S2000magician. I am curious–why do bond issuers use Treasury rate + spread to determine the call price? Why not use any other rate (such as YTM at the time of issuance) minus spread? I’d appreciate your thoughts.
Treasury rate + Spread = Required rate of return of the bond holder. So it is used to discount future payments to determine call price.
Hope it’s helpful.
I have no idea.
If I were to hazard a guess, it’s to ensure that the call price is related to (and greater than) the market price of the bond on the call date, which will depend on yields on that date, not on yields on the day the bond was issued.