The Disadvantages of Deferred Call Bonds

by Michael Wolfe

When a company chooses to issue a bond, then it will often allow itself the option of paying off the bond before its scheduled date of maturity. This is known as calling the bond, and a bond with this option is known as a callable bond. A bond with a deferred call is one in which the bond cannot be called immediately, but must be called at some point after it is first issued. These bonds carry several disadvantages to both the issuer and the investor.

Expense

One of the main disadvantages to investors of deferred call bonds is that they are more expensive to issue than regular bonds. This is because callable bonds put investors at a disadvantage, as they may be taken back by the issuer at any time. Therefore, the investor is required to pay more money, in the form of interest, to compensate the investor.

Uncertainty

For investors, the chief disadvantage of deferred call bonds is that they do not allow firm financial planning. This is because the bonds could be called back at any time -- at least, any time after the deferred call date. This means that the investor cannot plan on receiving income from these bonds. Instead, he may have to reinvest the money he receives from the call.

Limit Appreciation

One of the advantages of buying bonds is that their value can increase, depending on the direction interest rates move. For example, if a bond promises a set amount of interest over a set period of time, during which time interest rates fall, the bond will appreciate. With bonds that can be called back, this does not happen as much, as the issuer will likely call them back if interest rates fall, and then issue a new bond at a lower rate.

Not Without Risk

Although deferred call bonds limit the risk incurred by the investor, they do not allow the issuer to be entirely risk free, as the issuer cannot call the bonds back immediately. This means that, unlike with callable bonds without a deferred call date, the issuer may face a sudden change in interest rates before the deferred call date has arrived.

References

  • "Economics"; Roger A. Arnold; 2009

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