What is the Make-Whole Call Provision?
A Make-Whole Call Provision stipulates that the borrower has the contractual right to redeem a debt obligation prior to the original maturity date.
Bond Issuances with a Make-Whole Call Provision
The make-whole call provision allows the borrower to pay off (i.e. retire) outstanding debt before the call period.
If invoked, the borrower is subject to make a lump sum payment to bondholders per the conditions outlined in the lending contract.
The bond issuer could seek to redeem the bonds early for potential reasons including:
- More Attractive, Long-Term Financing Options
- Avoidance of Covenant Breaches
- Reduction of Debt (and Default Risk) in Capital Structure, i.e. Adjust Debt-to-Equity Ratio
- Excess Cash on Hand
The inclusion of make-whole call provisions has become standard for bond issuances, such as investment-grade corporate bonds and riskier types of high-yield bonds.
If the debt is retired early, the bondholders receive less interest since the bonds are not held until maturity, resulting in lower yields.
As a result, bondholders in response demand equitable compensation as a punitive measure to borrowers, i.e. to ensure they are “made whole” in exchange for the early repayment.
Make-Whole Call in Bond Indentures
Like most lending terms in bond indentures, the make-whole provision is a highly negotiated form of financing among the borrower and lender(s).
Within the bond indenture, which is the lending agreement, the specifics regarding the make-whole provision state the conditions necessary to be met for the issuer to proceed with calling the bond.
Generally, the make-whole compensation is higher than the current market price of the bonds.
Since most make-whole settlements are significantly above the par or market value of the bonds, the issuer can attach the provision as a deal “sweetener” to increase the marketability of the issuance – which particularly appeals to yield-chasing lenders.
Make-Whole Call Premium
The optionality to retire debt ahead of schedule comes at a cost to borrowers, typically in the form of a hefty premium in excess over the current (or par) value of the bonds.
Considering the make-whole call provision is intended to offset the losses incurred by bondholders, the compensation should amount to the par value at the bare minimum.
The premium is most often viewed relative to either the:
- Face/Par Value of the Bonds
- (or) Current Market Price of the Bonds
Starting from the minimum threshold (i.e. the par value), bondholders can negotiate different structures to obtain an applicable premium beyond the full recovery of the initial capital amount.
In fact, certain bondholders often seek to profit from the shortened lending term opportunistically – plus demand more compensation for the reinvestment risk, i.e. finding a new borrower in a potentially unfavorable credit environment.
Make-Whole Call Premium Calculation
The make-whole premium is the value of all future interest and principal payments, discounted to their present value (PV) at a pre-specified rate.
Ordinarily, the precise amount of a call premium is derived from pre-determined pricing formulas, where future payments are discounted to the present date – i.e. the net present value (NPV).
The remaining contractual cash flows (e.g. principal repayment and unpaid/accrued coupons) are discounted, often at a marginal spread above government-backed securities with comparable maturities (i.e. risk-free Treasury notes/bonds).
The standard lump sum payment settlement structure is composed of two parts:
- Pre-Determined Call Price
- Net Present Value (NPV) of Unpaid/Accrued Coupon Payments
The extent to how much the make-whole settlement amount is above the fair value of the bonds is dependent on the issuer’s current spread above the chosen benchmark rate.
Make-Whole Call vs Traditional Call
The make-whole call provision and the traditional call provision share certain similarities in providing the issuer with the right to retire debt early.
But traditional call provisions can only be enacted after a strict non-callable period (e.g. “NC/2”) has passed.
In effect, the “cost” of the make-whole call provision exceeds that of traditional call provisions, which come with a set call schedule and fixed call price.
Voluntary Covenant Breaches
A long-standing, controversial topic is how companies could theoretically violate covenants set by bondholders voluntarily.
The bondholders could demand immediate repayment in a case of covenant breach, but if immediate repayment could only be at par, then the main beneficiary in such cases is the borrower rather than the lenders.
But Wilmington Savings Fund Society, FSB v. Cash America International, Inc. ruled that certain covenant breaches, determined to be “intentional,” could entitle the bondholders to be paid the make-whole amount.
Still, a borrower could continuously breach covenants – whether intentional or not – aware that bondholders, especially as unsecured lenders placed lower in the capital structure, are unlikely to force default as the odds of full recovery are not in their favor during bankruptcies or as part of restructuring processes.
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