Bond Selection a "Make-Whole" Call Allows the Essay

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Bond Selection

A "make-whole" call allows the issuer of a bond to pay off the bond early. The payment to the bondholder is based on the net present value of the future payments remaining on the bond (Investopedia, 2012). This provision does not necessarily make the investors whole. The investors receive the net present value of the future payments on the bond. For the investor, the discount rate used to calculate the net present value should be the same rate at which the investor can re-invest those funds with the same risk level. In many cases, however, the discount rate used for the NPV payment would either be written into the provision, or would be determined by the bond issuer. Thus, the discount rate could be a higher or lower than the reinvestment rate of the investor. So while there is no guarantee that this provision would fail to make the investor whole, there is the risk to the investor that he or she might not be made whole should the provision be called.

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There should not be a difference between the zero coupon and regular coupon bond at the time of issue. They should both reflect the current risk situation with respect to prevailing interest rates, so that the yield to maturity is neural to the type of bond issued. Over time, however, changes in interest rates would have an impact on the value of the bond. Thus, whether a zero coupon bond or a normal coupon bond is better would depend on the issuer's view of future interest rate changes. Unless there is a compelling financial reason to issue a zero coupon bond -- and bear in mind that expectations of future rate changes are basically gambling -- I would recommend a regular issue simply because there is a bigger market for regular bond issues than there is for zero coupon bond issues. I would also recommend offering a normal call feature rather than a make-whole call feature. The risk associated with the make-whole feature that could result in a….....

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