What is a Make-Whole Call Provision in a Bond?

A make whole call provision, also sometimes known as a Doomsday Call, is a type of call provision attached to a bond that allows the borrower, or bond issuer, to pay off the remaining debt to the lender, or investor before the bond matures. A make whole call provision involves a lump sum payment made to the investor that is derived from a formula based on the net present value (NPV) of all future coupon payments that will not be paid incrementally because of the call, combined with the original principal payment that the investor would have received at the time of maturity of the bond.

How Does a Make Whole Call Provision Work?

The purpose of the make whole call provision is to ensure that investors are not left in the lurch when bond issuers decide to repay bonds early. Such a provision is vital to income investors who rely heavily on the cash flows from coupon payments as primary income sources. Since the costs associated with making the make whole payments are significantly high, a make whole call provision can be said to serve as a deterrent to companies against exercising any such early debt settlement measures. Make whole call provisions are typically included in the indenture of the bond. This practice of including such provisions in bond indentures began towards the end of the 20th century. It should be noted here that although make whole call provisions are explicitly defined, bond issuers rarely need to exercise this type of call provision. However, in the event that the bond issuer actually decides to make such a call on its bond, the investors will be guaranteed a calculated compensation (i.e. guaranteed to be made whole) for the remainder of the payments as well as the principal from the bond as mentioned in the bonds indenture. During a doomsday call, the issuer provides the investor with a lump sum payment based on the net present value (NPV) of all the future coupon payments that will not be paid incrementally because of the call, in addition to the par value principal payment of the bond. The disbursement of such a lump sum payment as well as the formula for its calculation is agreed upon in the make whole call provision within the indenture. In such calls, the market discount rate usually determines the NPV. Bond issuers typically resort to exercising make whole calls when the rates have decreased so much as to push the discount rate for the NPV calculation well below the initial rate included in the offering of the bond. Although such a situation may prove to be extremely beneficial to the investor, it will also increase the cost of the make whole call payments for the issuer. 

Example of a Make-Whole Call Provision

A make whole call provision, also sometimes known as a Doomsday Call, is a type of call provision attached to a bond that allows the borrower, or bond issuer, to pay off the remaining debt to the lender, or investor before the bond matures. A make whole call provision involves a lump sum payment made to the investor that is derived from a formula based on the net present value (NPV) of all future coupon payments that will not be paid incrementally because of the call, combined with the original principal payment that the investor would have received at the time of maturity of the bond.

The make whole call provision can be illustrated with the help of the following example. 

Suppose, investor I1 buys from company C1, a bond that matures in twenty years. Now let us assume that this particular bond makes semi-annual payments of $1,000 and also includes a make whole call provision. This means that investor I1 is due to receive a total coupon payment of $40,000 at $2,000 per year. However, with the passage of 17 years of the bond, the policy makers at company C1 realize that interest rates have decreased considerably and as such, it would be much more profitable for the company to pay off the bonds early and borrow at the current interest rates. This essentially means that investor I1, who has already received $34,000 in coupon payments over the past 17 years, now stands to get his entire investment back three year early, while relinquishing his claim to the last three years of coupon payments worth $6,000. Nevertheless, the bond has a make whole call provision and as such, company C1 is obligated to return investor I1s principal as well as the present value of the $6,000 that he is forgoing as a result of the early repayment.