Callable Bonds Revisited

Abstract

"In light of the dramatic changes in the callable bond market, we reexamine the determinants of callable bonds. Using data from 1980-2003, we find that callable bonds are often issued by firms with both information asymmetry and underinvestment problems. However, risk-shifting does not appear to be a major factor. Furthermore, we find that interest rate hedging is an important factor for investment-grade bonds and when interest rates are high but not so for below-investment-grade bonds or when rates are low." Copyright (c) 2010 Financial Management Association International.

Financial Contracting and Re-Rating Experience, the Cases of Make Whole, Claw Back and Other Wise Ordinary Callable Bonds

“…King and Mauer 2000, Mitchell 1991) and listing, bond market and firm effects (e.g. Banko and Zhou 2010, Nayar and Stock 2008, Crabbe and Helwege 1994, Thatcher 1985. Therefore we must control for all of these confounding influences.…”

“…Following Kraus (1973) finance has largely rejected interest cost savings as an explanation for call provisions since in an efficient market gains to shareholders via refinancing at lower interest rates would be anticipated and 6 expropriated by bondholders in the terms of the initial call provision. Recently Banko and Zhou (2010) find that ordinary call provisions are useful for hedging interest rate uncertainty but only for investment grade bonds.…”

“…However, Crabbe and Helwege (1994) find that the confounding effects of maturity, default risk and varying trends in the popularity of call provisions make it difficult to empirically verify if any of the specific agency problems can explain the use of ordinary call provisions. Banko and Zhou (2010) reply to Crabbe and Helwege (1994) finding that ordinary call provisions are useful in dealing with a combination of underinvestment and asymmetric information problems rather than each agency problem in isolation. Additionally several authors provide explanations why firms can employ a sub optimal call policy.…”

“…This helps ensure that the otherwise callable bond sample can act as a control sample since make whole and claw back provisions are supposed to resolve the underinvestment problem for the firm. Banko and Zhou (2010) and Crabbe and Helwege (1994) note that the use of call provisions vary through time so to ensure that there is no difference in the trend in the use of make whole, claw back and otherwise callable bonds we plot the number of bonds by offering year and call provision type in Figure 1. This figure shows that prior to the 1995 offering year the database is dominated by otherwise callable bonds except for a single spike of make whole bonds in 1989.…”

“…The situation is made more puzzling because Banko and Zhou (2010) find that the classic call option is used to resolve a combination of asymmetric information and underinvestment problems. Therefore the justification for refinements of the classic call option is not clear as firstly, the classic call option seems able to handle the underinvestment problem anyway and secondly, the existing empirical evidence does not examine whether make whole and claw back bondholders actually benefit from the resolution of agency problems.…”