2.3.1.3 Optional Redemption
The issuer’s ability to pay debt before its scheduled maturity can be valuable for purposes including the following:
- Debt reduction
- Relief from covenants and release of assets (revenues, property, or reserve funds) securing debt
- Debt restructuring
- Debt service savings
The issuer’s ability to reduce balance sheet debt is useful if unexpected or excess funds are available, if the repayment of debt may release the issuer from a pledge of assets needed for other purposes or the issuer seeks to relieve itself of financial or operating covenants that are unduly burdensome. Debt restructuring can consist of a change in interest rate mode (e.g., fixed rate to variable rate or variable rate to fixed rate) or a rescheduling of principal (e.g., deferring principal payment to later dates to reduce short term debt service or moving principal payment dates to level out annual debt service). Each of these goals can be achieved through a legal defeasance of the debt to its maturity date. See Section 3.7.6, Refunding Bonds. The cost of a legal defeasance to maturity can, however, be significant.
Debt service savings on fixed rate debt can be achieved by issuing new debt to prepay outstanding debt if the interest cost of the new debt is sufficiently lower than the cost of the outstanding debt. This may be because of improved issuer credit, selling on the shorter end of the yield curve or, most often, because of lower prevailing market interest rates. This savings must offset the cost of a defeasance and the cost of issuing and selling the new debt. A right of optional redemption, with the optional redemption available early, enhances savings prospects. See Section 3.7.6, Refunding Bonds.
From an investor’s perspective, the redemption of a bond for a price less than what the bond’s value would have been had it been “non callable” (required to be left outstanding and bear interest to maturity) is an economic loss against which the investor may demand compensation. For variable interest rate bonds, on any date on which the interest rate on the bond is reset to the rate that allows the bond to be marketed at par (or for VRDOs with a “daily” or “weekly” rate adjusting the value to par at short intervals), the bond will not be worth more than its principal amount plus accrued and unpaid interest. In that case, the loss to an investor through a par redemption is minimal and issuers generally have wide optional call flexibility. With respect to fixed rate debt and variable rate debt for which the interest rate will not be reset for some time, however, a decline in market interest rates could make a bond worth considerably more than its principal amount plus accrued and unpaid interest. In that case, investors desire protection against and/or compensation for an optional redemption.
Investor protection or compensation may come in the form of “call protection” and/or a “redemption premium.” A redemption premium can be expressed as a percentage of the principal amount of the bond redeemed, generally declining to par over time. Call protection precludes an optional redemption of a bond before a particular date and a redemption premium is an amount that must be paid to the bondholder to redeem a bond in addition to principal plus accrued and unpaid interest. As a general matter, the shorter the call protection and the lower the redemption premium, the higher the interest rate will be demanded by the investor. The optimal optional redemption provisions vary from transaction to transaction, depending upon the issuer’s need for flexibility and general market conditions. A “10 year par call” (optional redemption with no premium allowed from the date 10 years after issuance) is sometimes referred to as a “standard call provision” for long-term, fixed rate debt.
EXAMPLE OF A PAR CALL
First 10 years after bond issuance – Bond not subject to optional redemption
More than 10 years after bond issuance – Bond subject to optional redemption at a price of 100% of the principal amount thereof (plus accrued interest)
EXAMPLE OF A PREMIUM CALL
First 10 years after bond issuance – Bond not subject to optional redemption
10–11 years after bond issuance – Bond subject to optional redemption at a price of 102% of the principal amount thereof (plus accrued interest) 11–12 years after bond issuance – Bond subject to optional redemption at a price of 101% of the principal amount thereof (plus accrued interest) More than 12 years after bond issuance – Bond subject to optional redemption at a price of 100% of the principal amount thereof (plus accrued interest)
A redemption premium can also be a “make whole” premium calculated according to a formula. A make whole premium is designed to pay the bondholder the market value of its bond (if greater than the outstanding principal). Any make whole redemption calculation formula will be an imperfect measure of value, and the formulas investors generally require tend to overvalue the bonds redeemed. Tax exempt bond issues rarely have make whole redemption provisions. Taxable bond issues may have either make whole redemption provisions or redemption provisions similar to those in tax exempt bond issues. Often, taxable bonds will provide for make whole redemptions before the optional call date.