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

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.