THE CHOICE BETWEEN CALLABLE AND NONCALLABLE BONDS

• Published date: 01 December 2014
• Author: Frank Skinner,Laurence Booth,Dimitrios Gounopoulos
• DOI: http://doi.org/10.1111/jfir.12042
• Date: 01 December 2014

THE CHOICE BETWEEN CALLABLE AND NONCALLABLE BONDS

Laurence Booth

Rotman School of Management

Dimitrios Gounopoulos

University of Sussex

Frank Skinner

Brunel University

Abstract

We examine the choice and the offer spreads between callable and noncallable bonds. We

find significant differences by industry sector and therefore segment our results by

financial and nonfinancial industries. For the financial sector, the popularity of callable

and noncallable bonds is significantly related to the economic environment. Financial and

high‐grade nonfinancial callable bonds are also more likely to be issued via a shelf

prospectus. Although firms that issue callable bonds do not consistently display the

characteristics associated with severe agency problems, the issue choice for below‐

investment‐grade nonfinancial and lower rated financial bonds, where we can expect

agency problems to be more severe, is more consistent with agency theory than is the

issue choice for higher rated bonds.

JEL Classification: G24, G32, G38, K12, K22

I. Introduction

In recent years, many observers have noted that the popularity of callable bonds is

declining. For example, Kalotay (2008) and Banko and Zhou (2010) observe that the

portion of callable bonds have been declining over the last 20 years and their popularity

has shifted toward the below‐investment‐grade segment of the corporate bond market.

However, no explanation is offered for this trend. In contrast, our more recent sample

finds that new issues of callable bonds are becoming increasingly popular. Figure I shows

that although only 20% of all newly issued, U.S. dollar, fixed‐coupon corporate bonds

were callable in 1995, year by year the popularity of callable bonds increased until 2006,

when the popularity of callable bonds again decreased. We do not know why there is such

a variation in the choice between callable and noncallable bonds. Therefore, we develop a

set of hypotheses and test them in an attempt to explain why the popularity of call

provisions changes.

We gratefully acknowledge Kenneth Daniels, Demissew Ditro Ejara, Lei Zhou, and Mel Jamesson; the

seminar participants at Middlesex University, particularly Ephriam Clark and Yacine Belghitar; and the participants

of the 2013 Multinational Finance Society Conference in Izmir for their comments and suggestions. All remaining

errors are our own.

The Journal of Financial Research Vol. XXXVII, No. 4 Pages 435–459 Winter 2014

435

© 2014 The Authors. The Journal of Financial Research published by Wiley Periodicals, Inc. on behalf of The Southern Finance Association and the

Southwestern Finance Association.

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A call option empowers the issuer to take advantage of bondholders by repaying

the debt in advance when marketyields decline. When interest rates decrease, the call price

is less than what the fair value of debt would have been absent the call option. Following

Kraus (1973), finance has rejected financial gain as an explanation for call provisions

because in an efficient market, gains to shareholders via refinancing at lower interest rates

would be anticipated andexpropriated by bondholders in terms of the initial call provision.

Instead, Thatcher (1985), Kish and Livingston (1992),and Boreiko and Lombardo (2011)

suggest agency can explain the use of call provisions. Although earlier empirical studies

such as Crabbe and Helwege (1994) couldnot find empirical support for individual agency

theoretic explanationsfor callable bonds, more recent work by Banko and Zhou (2010) and

Chen, Mao, and Wang (2010) finds that call options are used to resolve a combination of

asymmetric information, underinvestment, and risk‐shifting agency problems.

Another argument suggests that some issuers can use callable bonds to hedge

interest rate risk. In fact, Banko and Zhou (2010) find some evidence of this for

investment‐grade callable bonds. Recently, Choi, Jameson, and Jung (2013) observe that

asymmetric information creates an incentive to issue callable debt even when market

conditions do not support a separating equilibrium. This happens because information

asymmetry that leads the market to overestimate the issuer’s default probability also leads

it to undervalue the call premium. Still, agency theoretic, asymmetric information, and

hedging rationales for call provisions do not provide an explanation for the time‐varying

popularity of callable bonds.

This raises several interesting questions. Are there any economic factors that can

explain the shifting popularity of callable bonds relative to noncallable bonds? If so, do

firms that issue callable bonds take into account these factors and does this influence the

preferred practice of issuing callable bonds? Do firms that issue callable bonds display any

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Callable Noncallable

Figure I. Proportion of All Newly Issued, U.S. Dollar, Fixed‐Coupon Corporate Callable and Noncallable

Bonds by Year from 1995 to 2007.

436 The Journal of Financial Research