The Choice Between Callable and Noncallable Bonds

Abstract

We examine the choice and the offer spreads between callable and noncallable bonds. We find significant differences by industry sector and therefore segment our results by financial and nonfinancial industries. For the financial sector, the popularity of callable and noncallable bonds is significantly related to the economic environment. Financial and high-grade nonfinancial callable bonds are also more likely to be issued via a shelf prospectus. Although firms that issue callable bonds do not consistently display the characteristics associated with severe agency problems, the issue choice for belowinvestment-grade nonfinancial and lower rated financial bonds, where we can expect agency problems to be more severe, is more consistent with agency theory than is the issue choice for higher rated bonds. characteristics associated with agency problems? Finally, do issuers pay a premium for the call feature?This article is related to a series of studies that examine the motivation and offer spreads of different types of callable bonds. Daniels, Diro Ejara, and Vijayakumar (2009) examine the motivation and offer spreads of bond clawbacks, and Nayar and Stock (2008) study make-whole bonds. Clawbacks and make-whole bonds are special types of callable bonds that restrict the refunding of callable bonds to issues of equity (clawbacks) or adjusts the call price at the date of call (make-whole). Banko and Zhou (2010) revisit the agency theoretic explanations for callable bonds, and Chen, Mao, and Wang (2010) examine the refunding behavior of callable bonds. We add to this body of work by examining the time-varying popularity of ordinary callable bonds and the influence that the issue process, bond covenants, and economic environment have on the offer spread for callable and noncallable bonds and on the value of call premiums. Unlike most studies in this area, we include financial firms as a larger number of callable bonds are issued by financial firms than by industrial and utility bonds combined during our 1995-2008 sample period. We also include financial bonds in our sample because we wish to determine whether the financing of financial firms is subject to the same agency theoretic problems as industrial firms.Other work includes the influence of the economic environment on the popularity of callable bonds, but evidence is fragmentary and contradictory. For example, Kish and Livingston (1992), Güntay, Prabhala, and Unal (2002), and Banko and Zhou (2010) find that the popularity is increasing, but Sarkar (2001) finds that the popularity of a call feature is decreasing in the level of interest rates. However, all of this work occurs during the time the call feature was being reengineered through the introduction of make-whole and clawback refinements to the call feature (see Goyal, Gollapudi, and Ogden 1998;Nayar and Stock 2008). Moreover, none of this work accounts for the full range of interest rate and credit risk environment variables. In contrast, we examine the impact of the economic environment by including proxies fo...

The Myth of the Credit Spread Puzzle

“…The table shows that the number of bonds with a low rating of B or C is small; for example there is only one C-rated bond in the maturity group 13-20 years. The reason is that speculative-grade bonds frequently contain call options which leads to their exclusion from our sample (see also Booth et al 2014). In the following we report results for ratings B and C with the caveat that these results-particularly for long maturities-are based on few observations and therefore are noisy.…”

Are Low Equity R2 Firms More or Less Transparent? Evidence from the Corporate Bond Market

“…While Table demonstrates the informational implications of Synchronicity among issuers with the potential for agency conflicts associated with financial distress, the positive significance of Synchronicity implies that higher Synchronicity is associated with a greater likelihood of call provisions for firms that are not financially distressed. Prior research finds that changes in the economic environment motivate the use of call provisions by investment grade issuers (Booth, Gounopoulos, and Skinner, ). In (untabulated) pairwise correlation analysis, we find that higher Synchronicity among investment grade issuers is associated with greater exposure to business cycle fluctuations and, as such, interest rates.…”