Quick Answer
Call features let an issuer redeem bonds early (optional, mandatory sinking fund, extraordinary, or make-whole), while put features let the investor sell back to the issuer. Callable bonds trade at higher yields to compensate investors for call risk; always quote the lower of yield to call or yield to maturity, since that represents the worst case for the investor.
Now that you know the different types of municipal securities, you need to understand how they can be redeemed before maturity. Call features directly affect a bond's yield and price.
What Are the Types of Call Features?
| Call Type | Description |
|---|---|
| Optional call (par or premium) | Issuer has the right (not obligation) to redeem bonds before maturity, typically at par or at a small premium; usually after a call protection period (e.g., 10 years) |
| Mandatory call (sinking fund) | Issuer is required to redeem a portion of the bonds on a schedule; reduces outstanding principal over time |
| Partial call | Only a portion of an issue is called; bonds to be called may be selected by lottery or pro rata |
| Extraordinary call (catastrophe call) | Triggered by an unusual event (e.g., natural disaster, condemnation, acts of God); allows early redemption if the project can no longer generate revenue |
| Make-whole call | Issuer pays a premium calculated to compensate the bondholder for lost future income; the premium is based on a present-value calculation using a reference Treasury rate |
Exam Tip: Gotchas
- A mandatory (sinking fund) call is not optional. The issuer must redeem bonds on schedule, unlike an optional call.
- Partial calls: the bondholder does not choose. Bonds are selected by lottery or pro rata.
- An extraordinary call is triggered by disaster, not by market conditions. Natural disasters, condemnation, or acts of God, not falling interest rates.
Who Benefits From a Call Feature?
| Issuer | Investor | |
|---|---|---|
| Call advantage | Can refinance at lower rates when interest rates fall | N/A |
| Call disadvantage | Must pay call premium (if applicable) | Loses future income stream; faces reinvestment risk (must reinvest at lower rates) |
| Call protection advantage | N/A | Guarantees income stream for the protection period |
Pricing impact:
- Callable bonds trade at higher yields (lower prices) than non-callable bonds to compensate investors for call risk
- Yield to call (YTC) is calculated to the first call date; yield to maturity (YTM) is calculated to the maturity date
- For premium callable bonds: YTC < YTM (the call is the worst case); quote the lower yield
- For discount callable bonds: YTM < YTC (maturity is the worst case); quote the lower yield
Exam Tip: Gotchas
- Always quote the lower yield for callable bonds. For premium bonds, that's yield to call (YTC) because the call is the worst case. For discount bonds, that's yield to maturity (YTM) because maturity is the worst case.
How Does a Put or Tender Option Work?
- A put feature gives the bondholder the right to sell the bond back to the issuer (or a trustee/remarketing agent) at par before maturity
- Often found on variable-rate demand obligations (VRDOs)
- Provides liquidity to the investor
- Bonds with put features carry lower yields than comparable bonds without puts (because the put reduces the investor's risk)
The put is the opposite of a call:
- Call = issuer's right to redeem early (benefits the issuer)
- Put = investor's right to sell back early (benefits the investor)
Exam Tip: Gotchas
- Put features lower yields; call features raise yields. Puts benefit the investor (less risk = lower yield), while calls hurt the investor (more risk = higher yield).
- When interest rates fall, issuers call bonds to refinance at lower rates. Investors then face reinvestment risk because they must reinvest proceeds at the new, lower rates.
What Should You Check on Exam Day?
- Mandatory (sinking fund) calls are not optional; issuers must redeem on schedule
- Partial calls are selected by lottery or pro rata, never by bondholder choice
- Extraordinary calls are triggered by disaster, not by falling rates
- Always quote the lower yield for callable bonds: YTC for premium bonds, YTM for discount bonds
- Puts lower yields; calls raise yields, because puts reduce investor risk and calls increase it