Call and make me whole

One of the most overlooked features of a bond is a make-whole call provision but one can be forgiven for this because rarely does an issuer exercise this option. But however rare it is, it does happen. Just recently Macy’s (the famous retail store in the U.S) used this provision to early redeem its 8.375% 2025 secured bond on August 17^th. So, what is a make-whole call feature and how does it work and or differ from a standard call provision?

A make-whole call provision is a type of call provision on a bond which allows the issuer to repay the remaining debt early by way of a lump-sum payment to an investor. The lump-sum payment is intended to compensate the investor for forgoing the remaining cash flows of the bonds and is derived from present value (PV) calculations. The investor is then said to be “made whole” on his or her investment with the compensation payment. Like a standard call, a make-whole call provision allows an issuer to repay a bond before its scheduled maturity date. In a standard call, the call date and price are usually known before hand, but not so for a make-whole call. For the make-whole call the issuer only indicates the expiry date of the make-whole call provision and the spread to be applied to determine the discount rate for the PV calculations. 

Let’s use the called Macy’s bond as an illustration. The Macy’s bond had, inter alia, the following terms: (a) coupon rate of 8.375% p.a. payable semi-annually, (b) call date of June 15, 2022, (c) call price of 104.188, (d) maturity date of June 15, 2025, and (e) make-whole call at 50bps until June 15, 2022. Additionally, the bond had a remaining tenor to the call date of 298 days and the 298-day market interest rate was about 0.06%. 

The make-whole call on the bond meant that Macy’s had until June 15, 2022, to exercise this option and a spread of 50bps would be added to the market rate to determine the rate at which the remaining cash flows would be discounted at. To be made whole on the bond Macy’s needed to compensate the investor for the remaining 298 days of coupon and the principal amount due on the call date. Macy’s would also pay the investor for the accrued and unpaid interest as at the settlement date of 17^th August 2021. 

An investor who bought a face value of US$100,000 would require total compensation of US$112,563.00 comprised of accrued interest of U$1,442.36, coupon forgone of US$6,932.64. and principal of US$104,188.00. The discount rate to be applied for the PV calculations would be 0.56% (i.e., market of 0.06% plus 50bps). For the sake of simplicity, we can calculate the lump-sum payment as the PV of US$112,563.00 discounted at 0.56% for 298 days. The make-whole payment then works out to be approximately US$112,000.00. 

Alternatively, Macy’s could have offered to repurchase the bonds at the prevailing market price by way of a tender offer. The bond was trading at 109 prior to the call announcement on August 3^rd and perhaps would have been a slightly cheaper option for Macy’s. However, bondholders are not obligated to participate in a tender offer, and all are unlikely to do so especially when prevailing interest rates are extremely low. A make whole call, similarly to a standard call, removes any discretion on the part of bond holders and grants the issuer the authority to repay its debt in full.

In summary, a make-whole call is a certain way for an issuer to redeem a bond prior to its scheduled standard call or maturity date. However, the cost of a make-whole call can often be high as investors need to be compensated for or made whole on the remaining cashflows from the bond. Such provisions are therefore rarely invoked by issuers.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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