What Is a Provisional Call Feature?

A provisional call feature is a mechanism that enables the issuer of securities to call the issue early, even outside of the normal call window. This happens when a certain threshold is crossed. The purpose of a provisional call feature is to protect an issuer from being forced to honor the conversion at an unfavorable price. Typically, the terms of a provisional call are 150% of the conversion price for a period of 20 consecutive days.

Basics

Convertible securities often come with a unique provision known as a conditional redemption option. This feature permits the issuer to reclaim the security during a non-call period, subject to specific criteria, which typically include a predefined price threshold. In contrast, traditional callable bonds are typically subject to normal call features, allowing redemption only after a specified period, often a decade from the date of issuance.

Exploring Conditional Redemption Options

Conditional redemption options, often called provisional call features, allow issuers to advance the initial redemption date. This is contingent upon the common stock underlying the security trading at or above a predetermined level for an extended duration. The primary purpose of these features is to safeguard issuers from being compelled to honor conversions, such as converting a convertible bond into common stock at unfavorable prices.

For instance, a convertible bond may include a provisional call provision that can be triggered if the underlying common stock trades at 120% of the conversion price for a continuous 30-day period. This triggering price, or multiple, is commonly known as the "trigger price." Typically, the terms of a provisional call require the stock to maintain a value of 150% of the conversion price for 20 consecutive days.

Call protection holds significant importance for investors, as it secures the optionality of the convertible security and any yield advantage it offers over the underlying shares for a fixed timeframe. Generally, the longer the call protection period, the greater the benefit for investors.

Call protection can be classified into two main types: hard call and soft call provisions. Most convertible bonds incorporate hard-call provisions, ensuring that the bonds cannot be called before a predetermined timeframe has passed. In contrast, some convertible bonds may feature a soft call provision in addition to or instead of hard call protection. With soft call provisional protection, the bonds can be called provided that the share price of the underlying common stock exceeds a specific threshold.

Analyzing the Advantages and Drawbacks of Conditional Redemption Options

When considering investments, investors must assess the merits and demerits of a security's conditional redemption option:

Drawbacks

Uncertainty: A conditional redemption option introduces uncertainty regarding whether a bond will remain outstanding until its designated maturity date. This exposes investors to the risk of losing a bond that offers a higher interest rate when issuers decide to call in their bonds. In such cases, investors often find themselves compelled to reinvest in securities with lower yields. Furthermore, these calls generally curtail the expected price appreciation of a bond when interest rates begin to decline.

Advantages

Enhanced Yields: Bonds featuring a conditional redemption option tend to disadvantage investors by offering higher yields than non-callable bonds. However, higher yields alone may not always be sufficient to attract investors. To make these bonds more appealing, issuers often establish a call price that exceeds the bond's face value, or principal. The discrepancy between the call price and the principal is known as the "call premium."

Conclusion

Provisional call features are protective mechanisms for issuers. They allow early redemption under specific criteria, typically requiring the stock to maintain 150% of the conversion price for 20 consecutive days. Investors must weigh the uncertainty of premature loss against the advantage of higher yields through a call premium. Understanding these options is essential for informed investment decisions.