Make-whole call: how it works, how often is it used?

Ever wondered what are the mechanics behind the make-whole provision of many bonds out there? Here is a quick readout to give you some answers and a few stats.

A make-whole call is a type of call provision on a (fixed-coupon mostly) bond, allowing the issuer to repay the bond early. It involves a lump-sum payment, not lesser than the principal, to compensate for the opportunity cost associated with early repayment.

The lump-sum payment is derived from a formula based on the net present value (NPV) of the scheduled coupon payments and the principal repayment that the investor would have otherwise received, based on a predefined discount rate known as the make-whole margin, that comes on top of some reference rate. Make-whole call provisions are defined in the indenture of a bond.

Investors are better off with a make-whole provision rather than a standard call, since with a make-whole call they get the NPV of future payments, or the principal, whichever is greater. The reference rate is typically the yield of a government security that has a maturity close to that of the bond. Thus, bonds with make-whole call provisions usually trade at a premium to those with standard call provisions.

Make-whole calls are exercised when the credit spread of the issuer goes down: the value of the bond then increases, possibly above the make-whole amount, so that it makes sense for the issuer to refinance at a lower cost.

What happens when the interest rates move up or down is less straightforward: the value of the bond and the NPV of outstanding coupons (fixed) and principal vary in similar directions. Hence, it does not necessarily generate a situation where the former is above the later.

Now let’s put a few stats around those notions. What follows is based on an analysis of some 2k+ bonds that either reached maturity or were called (including using the make-whole provision) or remained outstanding during the period 2015-2020. This sample consisted of rated issuances in EUR, CHF, GBP, NOK & SEK of companies outside of the finance and insurance sectors.

Key observations made:

  • 53% of the bonds in the sample had a make-whole provision in their indenture.
  • Make-whole bonds carried the same average coupon level as non make-whole bonds.
  • 5% of the bonds with a make-whole provision were called each year (using it), usually around 2 years before maturity.
  • Called bonds had an average rating of BB/BB+ vs. an average rating in the sample of BBB/BBB+. And their average coupon was also higher than the average coupon rate of non-called bonds. Our explanation: credit spreads for more risky issuers have decreased substantially while those of less risky issuers have not varied as much. For instance, over the period, A+ rated bonds had a rather stable credit spread level (around 40-60bp), while BBB+, BB+ and B+ rated bonds saw a 20%, 25% and 30% decrease in their credit spreads respectively (interest rates also went down in the period but again uncertain effect). Another explanation is that those issuers that exercised their make-whole call were moving upward the credit scale.
  • Average make-whole margin of the bonds for which the option was exercised was higher than the average make whole margin of all make-whole bonds (50 vs 31 bp). The higher margin made it cheaper for the issuers to call the bond back.
In summary, during the period we looked at that is 2015-2020, the make-whole call provision has allowed a number of somewhat lower credit rating issuers to repay early in the context of contracting credit spreads for the more risky categories. A lower make-whole margin might have made it easier (marginally).
Also, the annual volume of make-wholes was quite sustained, representing 5% of all outstanding bonds. Which makes the make-whole call provision by no means anecdotical.

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