The Existence of Call Provisions

Call provisions are included in many corporate debt issues. Noncallable bonds are often issued with short and intermediate maturities by firms with high ratings. In a perfectly efficient market, the added coupon on a callable bond, the call premium, and the period of call protection should reflect the fair value of the prospect of exercise of the call option. There should be no net advantage to issue debt with call features. Consequently, the inclusion of call features on many corporate bonds is puzzling. Several possible explanations have been suggested. None of these is a very satisfactory one.

One possible explanation for inclusion of call features is superior knowledge on the part of corporate management about the future course of interest rates. If management had special information about a future decline in interest rates, the call feature could be included at a relatively small cost. This explanation is of questionable validity since it seems unlikely that corporate managers have special skill in forecasting future interest rates. A considerable proportion of corporate bonds are purchased by professional money managers for financial institutions. There seems to be very little chance for professional money managers to have consistently inferior forecasting ability compared to corporate managers.