The call price, also referred to as the redemption price, is the predetermined amount at which a callable security, such as a bond or preferred stock, can be repurchased by the issuer or borrower before its maturity date. In such cases, the issuer has the right, but not the obligation, to retire the security early by making a payment to the investor, equal to the call price, along with any accrued interest or dividends.
Explanation:
Callable securities, like bonds and preferred stocks, are issued with an embedded call option that grants the issuer the right to redeem or buy back the security at a specified call price. This option provides the issuer with flexibility in managing its liabilities, allowing it to refinance debt or take advantage of more favorable market conditions.
The call price is typically set above the par value, or the face value, of the security. It represents a premium paid to investors as compensation for the potential loss of future interest or dividend payments in the event of an early redemption.
When an issuer chooses to exercise the call option, it effectively terminates the security before its scheduled maturity. By doing so, the issuer can eliminate or reduce future interest or dividend payments associated with the security, especially when prevailing market interest rates are lower than the coupon rate on the security. This allows the issuer to reduce its cost of capital and potentially free up capital for other investments or debt refinancing.
Investors holding callable securities face the risk of receiving their investment back earlier than expected. This may lead to reinvestment risk if they must reinvest the proceeds at lower interest rates prevailing at the time of redemption. To compensate for this risk, issuers often offer higher coupon rates or dividends on callable securities compared to non-callable ones.
It is important for investors to review the call provisions associated with callable securities before making investment decisions. The terms and conditions related to the call option, including the call price, call dates, and redemption provisions, are usually outlined in the security’s prospectus or offering documents. Investors should carefully consider not only the potential risks associated with early redemption but also the potential benefits if market conditions favor early retirement of the security.
Example:
To illustrate the concept of a call price, consider a corporation that issues callable bonds with a face value of $1,000 and a coupon rate of 5%. The bond’s call price is set at $1,050, which represents a 5% premium over the face value. Suppose, after a few years, prevailing market interest rates decline to 3%. In this scenario, the issuer may choose to exercise the call option and redeem the bonds by paying investors the call price of $1,050 per bond.
By retiring the bonds early and making the call price payment, the issuer can replace the high-interest bonds with newly issued bonds at the lower prevailing interest rate. This action reduces the issuer’s interest expense and thereby lowers its overall cost of borrowing.
In conclusion, the call price is an important term for investors and issuers of callable securities. It represents the predetermined amount at which a security can be repurchased before its maturity date. Investors should carefully review the call provisions associated with callable securities to fully understand the risks and potential benefits of holding such investments. Similarly, issuers must consider the impact of early redemption on their cost of capital and overall financial strategy.