DP16239 Credit Risk and the Life Cycle of Callable Bonds: Implications for Corporate Financing and Investing

Author(s): Bo Becker, Murillo Campello, Viktor Thell, Dong Yan
Publication Date: June 2021
Keyword(s): Callable bonds, credit risk, Debt overhang, Investment Decisions
JEL(s): G21, G32, G33
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16239

Call provisions allow bond issuers to redeem their bonds early. While commonly observed, existing research offers limited insight into the purpose of this contract feature. We show that bond callability is designed to mitigate agency problems, with call features and execution being determined by credit spreads and issuer quality. Callable bonds have significantly higher yields and lower secondary market prices than non-callable bonds ("cost of callability"). Issuers call bonds when their credit quality improves. We provide novel evidence that callability reduces debt overhang affecting decisions ranging from capital investment to takeovers. Our results help explain the prevalence of call features and suggest that callability improves economic efficiency.