Making Sense of Make-Whole Calls

If you’re involved with your institution’s investment portfolio, you’re likely familiar with callable bonds.  Typically, they are securities containing an embedded call option that gives the issuer the right to redeem the bond before its maturity date, paying the principal back early to the investor. 

But if you invest in municipal or corporate bonds, you may also come across bonds with a make-whole call.  It’s similar to a regular call structure that allows the issuer to redeem the bond before maturity. 

Unlike standard calls that only repay the principal amount, make-whole calls go a step further by compensating investors for the entire present value of expected future cash flows, including both principal and interest payments.

Picture this: if a make-whole call is exercised, the issuer ensures investors are ‘made whole’ by redeeming the bond before maturity and reimbursing them for all the money they would have received had the bond reached its scheduled maturity date.

How a Make-Whole Call Works

When a make-whole call is exercised, the issuer calculates the present value of the remaining cash flows associated with the bond, including both principal and interest payments. This value is determined using a predefined discount rate or a market-based formula. The issuer compares this amount to the bond’s par value and pays the higher of the two to the investor.

Another difference between a make-whole call and a standard call structure is when the call can be exercised.  With a traditional call structure, the bond can only be called after a specific date, known as the lockout period.  However, a make-whole call can be exercised anytime during the bond’s lifetime after it’s issued.

Benefits for Investors

Generally, a bond featuring a make-whole call provision can be advantageous for investors, as they tend to receive compensation greater than the par amount when the call is exercised.  This becomes especially beneficial when interest rates are falling, providing a little additional offset against the lower reinvestment rate on a replacement bond.

However, it’s worth noting that while issuers may incorporate a make-whole provision in a bond, history shows that make-whole calls are rarely exercised because of the higher compensation cost for the issuer.  Because of that, an investor has to consider the possibility that the bond won’t be called and will be held to maturity instead.  In addition, the yield on a bond with a make-whole call is usually slightly lower than other call structures because of the make-whole benefit.

Make-whole calls aren’t as prevalent as a traditional call structure.  Where you’ll most likely run into them is with corporate issues and the occasional municipal bond.  But it’s good to be aware of them and understand how they work because they may present an interesting investment opportunity.