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∗
Corresponding author. Tel +1-803-777-4928. E-mail address: epowers@moore.sc.edu. We thank Brent
Ambrose, Frank Fehle, Shingo Goto, Brad Jordan, Steve Mann, Sattar Mansi, Ted Moore, Greg Niehaus,
Ellen Roueche, Stathis Tompaidis, and seminar participants at the University of South Carolina for helpful
comments.
Are Make-Whole Call Provisions Overpriced? Theory and
Empirical Evidence
Abstract
We use a structural model to examine whether make-whole call provisions - a recent yet
surprisingly common innovation in corporate debt markets - are fairly priced at origination.
The call provision cost is calculated as the callable bond yield minus the equivalent non-
callable bond yield, producing an incremental yield attributable to the make-whole call
provision. Model parameters are calibrated to match characteristics of the issuing firm,
bond, and yield curve at origination for a large sample of recently issued US corporate bonds.
Our analysis indicates that while our model successfully captures cross-sectional variation in
incrementals yields, observed values are significantly greater than model-generated values.
The discrepancy between model-generated and observed incremental yields persists even
after we incorporate selected market imperfections that should widen incremental yields.
Our conclusion is that make-whole call provisions at origination have been mispriced and
that issuing firms have been paying too much for the financial flexibility that the call provision
provides.
1 Introduction
It is well-known that there has been a decline in the prevalence of fixed-price call provisions
in US corporate bonds throughout the 1980s and 1990s (Brealey and Myers; 2003, p.708).
What is less well-known is that a new type of call provision, known as a make-whole call, has
recently supplanted fixed-price call provisions. For example, in 2001, the amount of newly-
issued corporate debt with make-whole call provisions was more than 30 percent greater than
the amount of non-callable and fixed-price callable corporate debt combined - see Figure 1
With a make-whole call provision, the call price is not determined by a price schedule,
rather, the call price floats inversely with Treasury rates. If exercised, the make-whole call
price is calculated as the maximum of par value or the present value of the bond’s remaining
payments. The discount rate used in the present value calculation is the comparable maturity
Treasury yield plus a spread (known as the make-whole premium) that is specified in the
bond’s indenture. Thus, as risk-free rates decrease, the call price increases. Conversely, as
risk-free rates increase, the call price decreases until the floor at par is hit.1
The primary benefit of make-whole call provision relative to a traditional fixed-price call
provision is that the floating call price virtually eliminates the incentive for the firm to call
when interest rates drop. Thus, interest rate risk that bondholders are exposed to via the
call option is significantly reduced. With reduced risk, bondholders should demand less
compensation for their short position in the option. The required compensation, i.e. the
cost of the call option, is further limited by the fact that make-whole premiums are always
set well below prevailing credit spreads. Since prices (both market and call) are inversely
1
For more detail on the characteristics and benefits of make-whole call provisions, see Mann and Powers
(2003b). Also see Emery, Hoffmeister, and Spahr (1987) who suggested indexing call prices well before
make-whole call provisions became prevalent.
1
related to yields (risk-free rate plus credit spread or make-whole premium), this ensures that
make-whole call options will be well out-of-the-money at origination. In our sample, for
example, make-whole premiums average approximately 25 bp, but at-issue credit spreads of
the associated bonds are 150 bp greater on average. In fact, most of these call provisions are
unlikely ever to be in the money. Since January 1995 for example, the 10-year Aaa credit
spread has never dipped below 32 bp, yet 79 percent of the make-whole premiums in our
sample are less than this value.2 Furthermore, the call provision’s floor at par ensures that
the call will always be out-of-the-money whenever the bond is trading at a discount.
Our primary objective is to determine what is fair compensation for the short position
held by make-whole call bond investors. Intuitively, the cost of the call provision should be
low, but how low? Mann and Powers (2003a, 2003b) estimate that at-issue yields of bonds
with make-whole call provisions average 11 bp more than yields of comparable non-callable
bonds.3 The lack of a model, however, prevents them from assessing whether this is fair
compensation. Our second objective is to understand how characteristics of the bond such
as time-to-maturity, of the issuing firm such as leverage, and of the yield curve such as its
level should affect the incremental yield. Again, without a model, insights thus far have been
To accomplish these objectives we first develop a structural credit spread model. In our
model, risk-free rates and firm cash flows are given by correlated stochastic processes while
default and call decisions are endogenous. Credit spreads for both make-whole call and
non-callable bonds are then calculated numerically. As noted, our primary interest is in the
2
In our sample, make-whole premiums range between 0 bp and 100 bp with a mean (median) value of
25.6 bp (25 bp); 99.3 percent are less than 50 bp. In comparison, the 10-year Aaa industrials credit spread
has ranged from a low of 32 bp in February, 1997 to a high of 130 bp in May, 2000.
3
In both papers, they measure the cost of the make-whole call provision by subtracting maturity and
rating-specific Bloomberg Fair Market Yields from observed at-issue yields for matched samples of make-
whole call and non-callable bonds. The resulting yield differential for make-whole call bonds bonds is 11
bp more than the differential for comparable non-callable bonds. In comparison, the yield differential for
fixed-price callable bonds is 45 bp greater than the equivalent non-callable value.
2
incremental yield attributable to a make-whole call provision and not in credit spreads per se.
Thus, for make-whole call bonds, we disentangle the default and call option components of
the credit spread by subtracting the predicted spread of an otherwise equivalent non-callable
bond. The incremental yield resulting from this calculation is the cost of the call option.
1,300 recently issued make-whole call and non-callable bonds. For each bond in the sample,
we calculate what its credit spread should be assuming that capital markets are friction-
less and that calls only occur when economically optimal. For make-whole call bonds, the
predicted incremental yield has a sample mean (median) of 2.75 bp (1.75 bp). Regression
analysis reveals that our model-generated values successfully capture cross-sectional varia-
tion in observed incremental yields. However, after controlling for a variety of other factors
such as liquidity and the macro-economic credit environment, we find that observed values
average more than 11 bp and that the difference between model-generated and observed
Recent research by Elton, et al. (2001) highlights the impact of imperfections such as
state taxes on corporate credit spreads. Similarly, we hypothesize that the disparity between
predicted and actual incremental yields can be explained by market imperfections that are
likely to increase the incremental yield. Thus, we extend the model by parameterizing and
incorporating three real-world market imperfections. The first imperfection is capital gains
taxes assessed on the difference between the call price and basis price of taxable investors
if the bond is called. The second imperfection is transactions costs that are imposed on
debtholders when they are forced to rebalance their investment portfolios following a call.
The third imperfection is an exogenous event which requires the firm to retire debt for a
3
reason other than the call being sufficiently in-the-money. For example, debt assumed in an
acquisition or merger might contain covenants that restrict the ability of the firm to con-
duct business. In this situation, early retirement of the acquired debt may be desirable. A
make-whole call provision, even though it is out-of-the-money relative to the market price
of the bond, may help the firm avoid and even costlier tender offer. After incorporating all
three imperfections, the model-generated mean (median) incremental yield increases to 6.07
bp (5.44 bp), bringing results closer to empirically observed values. Nevertheless, regres-
sion results still indicate that model-generated values are statistically significantly less than
Our results could potentially be due to misspecification of the model. Extensive robust-
ness checks, however, suggest that this is not the case. Since we concentrate on incremental
yields - calculated as the difference between make-whole call and equivalent non-callable bond
model-generated values may actually overestimate what should be the cost of a make-whole
call provision. One reason to believe this is because our structural model underestimates
credit spreads in general, a sympton common to many structural models (Eom, Helwege,
and Huang; 2002). This increases the model-generated incremental yield by pushing the call
provision closer to being in-the-money. We have also focused only on imperfections likely to
increase the incremental yield and have ignored others that might have the opposite effect.
Thus, we conclude that make-whole call provisions have been overpriced at origination and
issuing firms have paid too much for the financial flexibility provided by this innovative call
option.
The rest of our paper proceeds as follows. In section 2 we develop the model. The
data is described in section 3. In section 4 we use the data to calibrate the model for
individual bonds, calculate model-generated credit spreads, and discuss comparative statics
4
of the model. The model-generated credit spreads from section 4 are compared to real-
world at-issue credit spreads of both make-whole call and non-callable bonds in section 5.
In section 6 we extend the model and discuss alternative sources of the incremental yield.
Robustness checks of both the model and the empirics are provided in section 7, followed by
a conclusion in section 8.
2 Model
2.1 Time Line
At time zero the firm borrows an exogenous amount. The debt is a coupon bond with
principal due at maturity and is either non-callable or has a make-whole call provision. At
each instant, the firm generates cash flow by producing sales at a fixed cost. The residual cash
flow net of debt payments and production costs is paid to the equityholders as a dividend.
If cash flow is insufficient to cover debt payments, the firm can costlessly issue equity. Sales
and the risk-free rate are assumed to be correlated stochastic processes with a constant
correlation coefficient.4
At each instant, the firm decides to make the coupon payment and pay production
costs, or to default, in which case debtholders recover the firm’s value and equityholders
get nothing. For a callable bond, if default does not occur, the firm must decide whether
to call the bond or leave it in place. If called, the call price is calculated as the maximum
of par value or the present value of the remaining scheduled debt payments. The discount
rate for the present value calculation is the prevailing risk-free rate plus the make-whole-call
premium.
The firm is assumed to make optimal default and call decisions. Default occurs when
4
Acharya and Carpenter (2002) use a similar setting for analyzing fixed-price call provisions with the
principal difference being that we assume cash flows are stochastic while they assume firm value is stochastic.
See their paper for a detailed discussion of the antecedent modeling literature.
5
sales decline and the market value of the firm’s equity becomes zero. In contrast, a call
occurs when sales increase and the firm is able to issue an equivalent bond with a yield that
is less than the risk-free rate plus the make-whole call premium of the existing bond. Both
equity and debt are priced fairly taking into account the optimal call and default strategies
of the firm.
The short-term risk-free rate rt is assumed to follow a mean-reverting square root stochastic
diffusion process, described by the one factor Cox, Ingersoll and Ross (1985) (CIR, hereafter)
model:
√
drt = κr (r∗ − rt )dt + σ r rt dWr , (1)
where κr is the mean-reversion rate, r∗ is the long-term level to which the short-term rate
reverts, σ r is the instantaneous volatility for the short-term rate, and Wr is a standard
We assume that the firm continuously generates sales s through time. All production costs p
(p ≥ 0) are assumed to be fixed through time, regardless of the level of sales. Thus, the cash
flow available to pay debt and dividends is s − p. Sales for the firm are assumed to follow a
ds
= (r − α)dt + σ s dWs , (2)
s
where α is the convenience yield, Ws is a Weiner process under the risk-neutral measure, and
σ s is the instantaneous volatility coefficient. The Wiener processes Wr and Ws are correlated
6
Fixed production costs imply that even an unlevered firm can become financially dis-
tressed.5 A distressed firm can either costlessly issue equity (via a negative dividend) or
can shut down operations permanently; temporary shut downs are not allowed. The sales
level at which financial distress induces the unlevered firm to shut down is endogenously
determined such that the value of the firm is always greater than zero.
We assume that the firm issues a bond that has a continuous coupon payment rate of c per
unit of time and par value F at maturity T. The firm continuously pays dividends that equal
We consider two types of bonds: 1) a bond with a make-whole call provision and 2) an
option-free or non-callable bond. The call price of a bond with a make-whole call provision
is determined by the remaining maturity t and by the level of the risk-free rate r. The call
price M(r, c, F, m, t), t < T at which the firm can call its debt is calculated as the present
value of the remaining coupon payments c and par value F discounted at the risk-free rate
plus some prespecified premium m > 0. There is a floor for the call price specifying that it
cannot be lower than the face value of the bond F . For a bond that has T − t remaining
where P (r, t, x) is the price of a risk-free zero coupon bond paying $1 at time x, calculated
7
2γe(κr −γ)(x−t)2(κr −γ) 2κr r ∗ /σ2
r rB(x−t)
P (r, t, x) = ( −γ(x−t)
) e , where
2γ + (κr − γ)(1 − e )
−2(1 − e−γ(x−t) ) p
B(x − t) = , and γ = κ2r + 2σ 2r . (4)
2γ + (κr − γ)(1 − e−γ(x−t) )
The last two terms in equation 3 are the present values of the coupon payments and of the
The value of the unlevered firm equals the expected present value under the risk-neutral
measure of the discounted future cash flows taking into account the option to shut down
operations if sales are sufficiently low. Given the value of the short-term interest rate r
and the sales level s, the value of the unlevered firm V (s, r) is given by the solution to the
following problem
Z τ Rt
V (s, r) = max E (st − p)e− 0 rs ds
dt, (5)
τ 0
where E is the expectation under the risk-neutral measure, and τ is the stopping time
corresponding to when sales drop to the critical lower boundary at which the unlevered firm
For a levered firm having debt with characteristics c, F, T, M, where c is the coupon rate, F
is the face value, T is the maturity of the debt and M is the call price for each t < T and
risk-free rate r, the value of the firm’s equity is E(s, r, t). Equity’s value depends on the
8
where the stopping time τ either corresponds to the time of default, bond call, or maturity.
The function δ in (6) is given by δ(x) = 0 if x 6= 0 and δ(0) = 1. The details of equity
To calculate the value of the debt D, we need to consider the firm’s default and call strategy
(if applicable). At maturity T, the debt value is given by the minimum of par value F and
In the equation the subscripts denote partial derivatives. There is a boundary condition for
the value of debt when equity is valueless and the firm defaults:6
For a callable bond there is another free boundary condition that corresponds to the case
where the firm buys the debt back at the make-whole call price M(r, c, F, m, t):
In the absence of taxes, financial distress costs and bankruptcy costs, the value of the firm
V = E + D. (11)
6
This boundary condition assumes that assets of the levered firm are transferred to bondholders following
default. Note that the sales level at which the levered firm will default is greater than the sales level at
which the unlevered firm shuts down its operations.
9
3 Data
We calibrate and test our model using a sample of bonds drawn from the Fixed Income
Securities Database (FISD). The selected bonds have the following characteristics: (1) issued
on or after January 1, 1995, (2) maturity of at least one year, (3) denominated in US dollars,
(4) offering amount of at least $25 million, (5) fixed semi-annual coupon, (6) not asset backed,
(7) not putable, (8) without a sinking fund, (9) not a Yankee bond, (10) not a Medium Term
Note, (11) not part of a unit offering, (12) not convertible, and (13) listed as a Corporate
Debenture. These screens result in an initial sample of 2,511 non-callable bonds, 2,800 bonds
with fixed-price call provisions, and 2,447 bonds with make-whole call provisions.
We exclude bonds with fixed-price call provisions and those for which there is no infor-
mation in the FISD on the at-issue yield-to-maturity. We also eliminate make-whole call
bonds for which we are unable to determine the make-whole premium via either Bloomberg
or by direct inspection of the bond prospectus. These requirements reduce our sample to
2,262 non-callable bonds and 1,870 bonds with make-whole call provisions.
Using the 6-digit Cusip of the issuer provided in the FISD, we match each observation
to the corresponding prior fiscal year record in Compustat, the source for the issuer-specific
information required for our pricing model. Observations are lost either because the firm
is not listed in Compustat or because the bond was issued by a subsidiary of a firm rather
In columns one and two of Table 1, Panel A, we present means and medians for character-
istics of the firms responsible for issuing the 1,662 non-callable bonds and 1,583 make-whole
call bonds for which we have at least sales data for the issuing firm. In calculating these
statistics, we allow only one observation per firm, per bond type in each issue year. With
the exception of sales, all characteristics are winsorized at the 1st and 99th percentiles for
10
the entire Compustat universe in order to limit extreme outliers. Column three contains
p-values for t-tests and Wilcoxon Rank-Sum tests (in parentheses) of the null hypothesis
that means and medians for the associated variables are the same for the two samples.
As can be seen from the summary statistics, the typical issuer of a make-whole call bond
is smaller, more profitable, and appears to have greater growth opportunities (as proxied
by Tobin’s Q) than the typical non-callable bond issuer. Make-whole call issuers also have
greater book leverage. Average historical sales growth and volatility of sales growth are
significantly greater for the make-whole issuers (both variables are highly skewed), but there
is no significant difference in the respective medians. Finally, the volatility of the firm’s
daily excess equity return for the prior six months is significantly greater for make-whole
call issuers. Note that make-whole call bonds are more prevalent in the later half of our
sample period. Thus, some univariate differences are potentially due to different economic
Our initial sample includes 1,662 non-callable bonds and 1,583 make-whole call bonds.
Our final sample, however, is limited to 775 non-callable bonds and 612 make-whole call
bonds. Observations are lost/discarded when we parameterize our model for reasons such as
no equity price available which makes calculating a proxy for Tobin’s Q impossible, insuffi-
cient information for calculating the standard deviation of sales growth, or extremely high or
low input parameters. For the issuers of bonds that make it into our final sample, we report
all of the same summary statistics in columns four and five. All of the prior comparisons
that were significant remain statistically significant (p-values not reported in the table).
Panel B shows means and medians for characteristics of the actual bonds in the sample
(no bonds are excluded). The summary statistics indicate that the typical make-whole call
bond has a worse rating, longer maturity, and moderately larger offering amount than the
typical non-callable bond. The median make-whole call bond has a rating of BBB, 10 years
11
to maturity, and an offering amount of $300 million. In contrast, the median non-callable
bond has a rating of A-, 9 years to maturity, and an offering amount of $250 million.
Following Eom, Helwege, and Huang (2002), we calculate the credit spread as the bond’s
yield-to-maturity at issue minus the equivalent maturity Constant Maturity Treasury (CMT)
linearly using the two closest maturity CMT yields.7 The mean and median credit spreads
for the non-callable bonds are 117 basis points and 88 basis points, respectively. Consistent
with their lower ratings, longer maturities, and prevalence later in the sample period when
credit spreads are wider, the mean and median credit spreads for the make-whole call bonds
are statistically significantly greater at 179 basis points and 155 basis points, respectively.
Comparisons are similar for the final sample bonds reported in columns 4 and 5.
4 Model Output
4.1 Calibration
To use the model, we require parameter values for the risk-free interest rate process (r, κr , r∗ , σ r ),
the sales process of the firm (σ s , ρ, p, α), and the capital structure of the firm (F, T, m, c). To
estimate the parameters of the risk-free process, we solve for the short-term rate r, the mean
reversion rate κr , the long-term rate r∗ , and the volatility σ r which minimize the sum of
squared deviations between the 1, 2, 3, 5, 10, and 30 year yields implied by the closed-form
solution of the CIR model and the real-world Constant Maturity Treasury (CMT) yields for
the same maturities. This is done independently for each bond origination date.
For the firm, we approximate the volatility of the sales process σ s using the standard
deviation of annual sales growth for the prior 10 years. For ρ, the correlation between the
7
Duration bias is a potential concern since we are making a comparison to the equivalent maturity (not
duration) CMT yield. Our model-generated credit spread, however, will be reported on the same basis,
minimizing potential bias.
12
Wiener processes driving the risk-free rate and sales, we calculate the median correlation
between sales growth and changes in the short-term risk-free rate over the prior 10 years for
the firm’s industry. To approximate production costs for the firm p, we calculate the firm’s
Technically, the parameter α is the payout rate (or convenience yield) of the firm. The
primary effect of α, however, is that it adjusts the risk-neutral growth rate of firm sales;
when α is small (large), the growth rate is large (small). To set α, therefore, we need
EBIT
an estimate of growth expectations for the firm. While the ratio of T otal Market V alue
is a
theoretically appealing measure of growth in the context of the model, it is a noisy measure
in real-world data. Instead, we use a proxy for Tobin’s Q, ( TTotal Market V alue
otal Book V alue
) to measure
growth opportunities. This proxy for growth is common in the corporate finance literature
(see e.g. Shin and Stultz; 1998). Furthermore, regression analysis (results not presented in
tables) indicates that Q and observed credit spreads are significantly negatively related.
To map Q into α, we first calculate average observed credit spreads and Q for twelve
to typical 5, 10, and 30 year bonds in our sample with ratings of either Aa, A, Baa, or Ba.8
We then assume that the mapping between Q and α for these representative bonds has the
α = a + b ∗ ln (Q) . (12)
Finally, we solve for a and b such that the sum of squared relative prediction errors ((model-
generated spread - average observed spread) / average observed spread)2 is minimized for
8
To calculate average observed credit spreads, we first regress actual at-issue credit spreads for our entire
sample of non-callable bonds on a variety of observed characteristics, the most important being issuing firm
leverage and bond maturity. The estimated coefficients from this regression are then used to calculate average
credit spread values for our twelve representative bonds. For a medium term Baa bond for example, we set
leverage equal to the average leverage value for medium term non-callable Baa bonds in our sample, set
maturity equal to 10 years, hold all other values constant at sample averages, and then calculate a predicted
value. A similar process is used to calculate average Q for the representative bonds.
13
the representative bonds. The resulting values are a = 0.0501 and b = −0.0136. These
values are then used in mapping Q into α for all sample bonds, including the make-whole
call bonds.9
For the capital structure of the firm, we first establish the degree of financial leverage by
setting the face value of debt F . Note that in the model there are no physical assets per se
and thus no book value of assets. We do, however, calculate the value of the firm. Thus,
Debt
leverage in the model corresponds to market leverage, T otal Market V alue
. While we could set
F to match observed market leverage, the observed value tends to be noisy and affected by
Debt maturity T is taken directly from the bond that we are analyzing; we are implic-
itly assuming that the bond’s maturity is representative of all debt in the firm’s capital
structure.11 Similarly, if the bond has a make-whole call provision then m is set equal to the
make-whole premium given in the bond’s indenture. To get the coupon rate c, we numerically
solve for the value such that the bond is priced at par. Thus, c is also the yield-to-maturity
of the bond.
9
While our transformation of Q into α may seem ad-hoc, it is a parsimonious method of getting our
model to approximate real-world credit spreads. This is a necessary first step if we want to value the credit
spread option given by the make-whole call provision. Other papers use similar methods to set appropriate
parameters (see Anderson and Sundaresan; 2000 or Huang and Huang; 2002).
10 Debt
In our data, book leverage ( T otal Assets ) is more highly correlated with at-issue credit spread (ρ =0.34)
Debt
than is market leverage ( T otal Market V alue ) (ρ =0.27).
11
Jones, Mason, and Rosenfeld (1984) note that contingent claims models are difficult to implement when
pricing individual bonds since the models must assume simple capital structures while real-world capital
structures are often quite complex. Empirical studies that analyze the effectiveness of structural models
such as Jones, Mason, and Rosenfeld (1984), Ogden (1987), and Eom, Helwege, and Huang (2003) finesse
this issue by focusing on firms with very simple capital structures.
14
4.2 Model-Generated Spreads
For each bond in the final sample, we parameterize the stochastic processes to match observed
characteristics of the risk-free yield curve, firm, and bond at the origination date. Table 2
displays the predicted credit spread relative to the model-generated comparable maturity
risk-free yield. For non-callable bonds, the mean (median) predicted spread is 81 (38) basis
points. For make-whole bonds, the predicted spread includes the incremental yield associated
with that bond’s make-whole call provision. The predicted spread for the make-whole call
To assess the general fit of our model, we provide summary statistics on prediction error
calculated as predicted spread minus observed spread. For non-callable bonds the mean
(median) value of the prediction error is -26 (-44) bp with a standard deviation of 98 bp.
For make-whole call bonds the prediction error is -35 (-48) bp with a standard deviation of
127 bp. We also report percentage prediction errors, calculated as prediction error divided
by observed spread.
While our model underpredicts credit spreads on average, its predictive ability is on par
with the structural models tested by Jones, Mason, and Rosenfeld (1984), Wei and Guo
(1997), Lyden and Saranti (2000), and Eom, Helwege, and Huang (2003). For example,
the absolute percentage prediction error is of similar magnitude to the two best performing
models tested by Eom et al. and reported in their Table 3.14 This is particularly notable
12
As will be seen later, most of the difference in predicted spreads between the non-callable and the make-
whole call bonds is not due to the make-whole call provision. Rather, it is due to systematic differences in
other characteristics as illustrated in Table 1.
13
A potential concern is our assumption that maturity of the individual bond is representative of all of the
firm’s debt. We calculate a weighted-average maturity of the firm’s debt listed in the FISD, excluding bank
debt and commercial paper, and subtract it from the maturity of the individual bond. The differential is
approximately the same for both types of bonds and has a mean (median) value of 1.2 (0.6) years. Therefore,
while our simplifying assumption will induce noise in our estimates, it should not induce bias.
14
The models tested by Eom et al. are an extended version of Merton (1974), Geske (1977), Leland
and Toft (1996), Longstaff and Schwartz (1995), and Collin-Dufresne and Goldstein (2001). Their best
performing models are Merton (1974) and Geske (1977).
15
given that all of the previously mentioned empirical studies limit their samples to bonds
issued by firms with simple capital structures, i.e., samples where structural models are
Regression analysis of the prediction errors (results not presented in tables) shows that
they are positively related to most of the firm and bond-specific model inputs such as lever-
age, volatility of sales, costs/sales, the payout ratio α, and maturity. The result is that we
tend to underestimate credit spreads for short-term and highly rated bonds and overestimate
credit spreads for long-term and poorly rated bonds. Eom, Helwege, and Huang (2003), An-
derson and Sundaresan (2000) and Huang and Huang (2002) all show that this is a common
for the two options owned by the issuer: (1) the option to default and (2) the option to call.
To estimate the incremental cost of the option to call, we subtract the predicted spread
for an equivalent non-callable bond from the predicted spread for the make-whole call bond.
Taking the difference in this manner should substantially reduce any unobserved bias possibly
introduced by the model. After differencing, we calculate the sample mean (median) model-
generated incremental yield to be 2.75 (1.75) basis points with a maximum of 22.1 basis
In a perfect capital market, the comparatively small incremental yield reflects two facts.
First, the firm will call only when it can profitably refund the existing bond with an equivalent
bond at lower cost. For this to occur, the credit spread on new borrowing for the firm must
be less than the make-whole premium and the market price of the bond must be above
par (or else the call price floor at par is binding). Given the small magnitude of make-
whole premiums, however, the likelihood of such a refunding opportunity is small. Second,
the small incremental yield reflects that the payoff to the firm from exercising the call is
16
capped.15
In this section, we examine how changes in underlying parameter values affect the incremen-
statics, we first parameterize a base case for our model. The parameter values for the base
case correspond to a typical bond in our sample and are as follows: r=4.77%, κr =0.171
per year, r∗ =6.01%, and σ r =10% annualized. For the sales process, values are σ s =11.4%,
F
ρ=0.027, p=78%, and α=4.56%. Finally, for capital structure, values are V
=18.5%, T =10
years, and m=24 bp. For these parameter values, the predicted credit spread for the equiva-
lent non-callable bond is 65.21 bp and the incremental yield attributable to the make-whole
call provision is 3.89 bp. Next, holding all other parameters constant, we vary each pa-
rameter by reducing it to approximately its 25th percentile value and then increasing it
to approximately its 75th percentile value. The resulting non-callable credit spreads and
The comparative statics indicate that in most cases, the incremental yield and the non-
callable credit spread are inversely related. The incremental yield is larger while the non-
callable credit spread is smaller for firms that have lower volatility of sales, lower leverage,
lower production costs, and greater growth opportunities. Given the competing nature of
the default and call options, these results are intuitive. As the option to default becomes
more valuable, the non-callable credit spread increases - a first order effect. The second
order effect, however, is a reduction in the value of the call option since firms that are more
likely to default have less incentive to exercise the call option. This leads to a decline in
15
If the make-whole premium is 25 bp, the most that the firm can save when refunding is 25 bp of yield.
For a bond with five years until maturity and a 7 percent coupon, discounting at 6.75 percent rather than
at 7 percent implies a savings of $10.46 per $1,000 of face value.
17
the incremental yield. For example, an increase in sales volatility from 11.4% to 17.4%
increases the non-callable credit spread from 65.21 bp to 170.04 bp while the incremental
yield declines from 3.89 bp to less than 1 bp. The inverse relationship between incremental
yield and non-callable credit spread also holds as the level of the yield curve varies; as the
risk-free yield increases, the non-callable credit spread narrows and the incremental yield
increases.
In most cases, there is little that issuing firms can do to adjust the parameters for which we
present comparative statics. This is not true, however, for the make-whole premium; issuing
firm are free to choose any value that they desire. Because of the practical importance of
the relationship between the make-whole premium and the incremental yield, we plot the
price. This results in a larger incremental yield. For the base case bond for example, an
We have two primary objectives in our empirical analysis. The first is to determine whether
our model captures the cross-sectional variation in the incremental yield associated with a
make-whole call provision. If so, then this helps to validate the comparative statics discussed
in section 4.3. The second objective is to compare the magnitude of observed incremental
To accomplish both objectives, we rely on regression analyses where the dependent vari-
able is the observed credit spread CSpo at origination. To control for the default component
independent variable NC CSpm . Note that for a make-whole call bond, this is the model-
18
generated credit spread for an equivalent non-callable bond. To capture the incremental
yield associated with a make-whole call provision, we include the model-generated incre-
mental yield for make-whole call bonds MW IYm . For non-callable bonds, MW IYm is set
equal to zero.
As our primary analysis, we estimate the following equation using Ordinary as well as
Robust Least-Squares:
If our model is a perfect representation of reality and our parameterization process is without
error, then we expect estimated coefficients of 0 for a0 and 1 for a1 and a2 . We also include
a variety of controls in the regression for bond, firm, and economy-wide factors which have
been shown to affect credit spreads but which are not incorporated in our structural model.
To account for exogenous variation in the credit environment due to macroeconomic fluc-
tuations, we include the difference between Moody’s Seasoned 10-year Baa corporate yield
and the 10-year Constant Maturity Treasury (CMT) rate (Baa CMT Sp). Throughout the
sample period, there is wide variation in the seasoned credit spread ranging from 124 to 383
basis points.16
Elton et al. (2001) show that low credit quality bonds expose investors to systematic
risk in addition to default risk. While this additional risk is reflected in real-world credit
spreads, it is not incorporated in our model and must be controlled for separately. Following
Eom, Helwege, and Huang (2003), we use an ordinalized rating variable (Aaa = 1, Aa+ =
2, Aa = 3, etc.) Since actual rating is correlated with our model-generated credit spread, we
16
During the sample period, there was a “flight to quality” during the Asian debt crisis of 1997 and the
Long-Term Capital Management and Russian debt crises of 1998. There was also a significant increase in
idiosyncratic equity volatility (Campbell and Taksler; 2003).
19
first orthogonalize the ordinal rating variable before including it in our primary regression.
We do this by estimating an ordered logit regression with ordinal rating as our dependent
variable and NC CSpm as the independent variable.17 The residual from this regression
Residual Rating is then included in our analysis of CSpo and functions as a proxy for all of
the characteristics of the bond and firm that we are unable to observe. For non-rated bonds
(71 cases), we replace the missing value for Residual Rating with a zero and then code a
Our model already incorporates a measure of firm volatility, however, Campbell and
Taksler (2003) find that the relationship between observed credit spreads and the volatility
of daily excess stock returns is significantly stronger than what is found when simulating
the Merton (1974) model. We expect that much of the extra explanatory power of idiosyn-
cratic equity volatility will already be controlled for via our inclusion of Residual Rating and
Baa CMT Sp.18 Nevertheless, we include Equity Volatility as an independent variable. Since
Chaplinsky and Ramchand (1997), Fenn (2000), and Livingston and Zhou (2002) find
that credit spreads for bonds issued privately under Rule 144a are significantly greater than
for comparable publicly issued bonds. The latter two papers also find that credit spreads are
greater for first-time bond issuers (see also Datta, Iskandar-Datta and Patel; 1997) and, after
controlling for rating, for bonds classified as senior. To control for private versus public, we
include a dichotomous variable Rule 144A that is coded one for the 13.8 percent of our bonds
that are privately issued. First Bond is coded one for the 17.5 percent of our sample where
17
Discussions with representatives of the two major bond rating agencies (Moody’s and Standard and
Poors) indicate that the existence of a make-whole call provision does not impact the rating assigned to a
bond. Thus, we do not include M W IYm when we orthogonalize.
18
In addition to finding a cross-sectional relationship, Campbell and Taksler (2003) show that aggregate
corporate yield spreads widen during periods of higher idiosyncratic volatility.
20
no earlier bond issued by the same firm is recorded in the FISD. Finally, Senior is coded
one for 94.9 percent of our bonds that are designated as either senior or senior-secured.
Elton et al. (2001), and Campbell and Taksler (2003) document that yield spreads for
bonds issued by financial service firms are between 10 and 20 basis points greater than yield
spreads for industrial bonds. Therefore, we include a dichotomous variable Finance that is
coded one for the 21.3 percent of our bonds that are issued by financial service firms and zero
otherwise. Bonds issued by utility firms comprise 6.8 percent of our sample. Since utility
firms are often regarded as distinctly different credit risks, we also include a dichotomous
Chen, Lesmond, and Wei (2002) show that bond liquidity is negatively related to credit
spreads. Their measure of liquidity is beyond the scope of this paper, however, they find that
their liquidity measure is negatively related to maturity and positively related to amount
outstanding. We include Log Offering Amount and Log Maturity, therefore, as controls for
liquidity. Including the log of maturity is also motivated by research indicating that the
observed term structure of credit spreads widens with maturity (Litterman and Iben; 1991,
Results from estimating equation (13) for the entire sample are displayed in Table 4. The
first column presents OLS estimates. The second and third columns present robust least
squares estimates.20 Inclusion of Equity Volatility distinguishes the specification in the third
19
Our model generates an upward-sloped credit spread term structure. It is unclear, though, whether the
observed slope is entirely due to the default risk captured by our model. Thus, it is prudent to include
log of maturity as an exogenous control. Subsequent results are robust to including dichotomous variables
distinguishing short-term, medium-term and long-term bonds.
20
The robust regression procedure available in Stata 7.0 °R
is an iterative weighted least squares process
where the weights are inversely proportional to residuals from a previous pass. This reduces the influence of
outliers.
21
column from the specification in the second column.
In each specification, the signs of estimated coefficients for the exogenous control vari-
ables are generally as expected and values are statistically significant. At-issue credit spreads
increase with Moody’s seasoned bond credit spread. The estimated coefficients for Resid-
ual Rating, our proxy for unobserved characteristics outside the scope of our structural model,
are positive and highly significant. Credit spreads are greater for: longer maturity bonds,
privately issued bonds, bonds that represent the first debt issue of the firm, and for bonds
issued by firms with volatile equity prices. Credit spreads are lower when the yield curve is
steeply sloped, the offering amount is large, and when the bond has seniority. The impact
The more important results are those that pertain to the model estimates. In the OLS
results of the first specification, The estimated coefficient for NC CSpm is 0.257 with a
tially less than one - the value that would be expected if our model and its parameterization
were a perfect representation of reality - the statistical significance suggests that our struc-
tural model does capture a significant amount of real-world variation in credit spreads.
The estimated coefficient for MW IYm is 6.219 with a highly significant t-statistic of
6.07. We caution that these results are sensitive to outliers in the data. Indeed, analysis
of the regression residuals shows that the variance of the residuals increases noticeably with
The difficulty with outliers can be almost totally eliminated by replacing CSpo , NC CSpm ,
and Baa CMT Sp with their respective logs and MW IYm with log(1 + MW IYm ).22 Inter-
21
This is consistent with Elton et al. (2001) who note that greater bond default risk leads to greater
credit spreads and to greater uncertainty as to the appropriate value of the bond. Similarly, Nejadmalayeri
(2002) and Joutz, Mansi, and Maxwell (2002) show that variation in credit spreads increases as bond rating
deteriorates.
22
Taking the log of M W IYm without first adding one is problematic since M W IYm is equal to zero for
22
preting coefficient in this regression, however, is not straightforward (results available from
authors.) Instead, we report robust OLS results in the second and third regression specifi-
cations. In the second specification, the estimated coefficient for NC CSpm declines from
0.257 to 0.184, but the t-statistic increases to more than 18. The estimated coefficient for
the incremental yield MW IYm also declines from 6.219 to 4.359 with a t-statistic of 8.46.
the estimated coefficients for the model-generated values. Including a dichotomous variable
identifying make-whole call bonds in addition to MW IYm (results not presented in tables)
Given our results, how do we interpret the estimated coefficients for MW IYm ? If the real
world pricing of make-whole call provisions perfectly coincides with our model’s predictions,
then we expect an estimated coefficient of one for MW IYm . Instead, estimated coefficients
are significantly greater than one for MW IYm ; the p-value of an F-test for MW IYm =
1 is .0000 for both specifications two and three. For the average make-whole call bond in
our sample, the baseline model predicts an incremental yield of 2.75 basis points. Empirical
results from the robust OLS regressions suggest incremental yields of 4.359×2.75 bp = 11.99
bp for specification two and 3.866×2.75 bp = 10.63 bp for specification three. Both values
The incremental yield generated by our model reflects the pure economic value of the make-
whole call provision. By pure economic value we mean the gains that the firm can seize
when credit spreads narrow to the point that the make-whole call provision is in-the-money.
In practice, there are alternative sources of incremental yield that are not captured in the
over half of the observations.
23
model. In the following subsections, we discuss and incorporate three market imperfections
that we believe might account for the disparity between model-generated and observed in-
cremental yields. These imperfections are capital gains taxes, transactions costs imposed
on investors when calls are executed, and exogenous events requiring the firm to retire debt
early. Other market imperfections such as transactions costs imposed on the firm when a
call is exercised might reduce the model-generated incremental yields. We choose, however,
to focus only on those that we think will increase model-generated values. Moreover, we try
If a make-whole call is exercised, a taxable investor will owe capital gains taxes whenever the
call price is greater than the investor’s basis value. For every make-whole call bond in our
sample, its offering price is at par or below — the mean (median) is 99.59 (99.70) percent of
par. Since the call price has a floor at par, taxable investors who purchased the bond when
issued will invariably owe capital gains taxes if the bond is called. Incorporating capital
gains taxes of 20 percent into our model has no impact on the non-callable credit spread. If
we assume that the marginal investor is taxed, however, the incremental yield for the base
case make-whole call bond increases by almost 2 bp from 3.89 bp to 5.83 bp.
A significant percentage of corporate bonds are held by institutional investors who often have
well-defined investment strategies. For example, the institution might follow a passive strat-
egy designed to match the risk profile and return of a benchmark portfolio. Alternatively,
the institution might follow an active strategy designed to capitalize on risk-arbitrage op-
24
portunities. In either case, exercise of a make-whole call provision can upset the investment
strategy and force the institution to rebalance the portfolio at an inopportune time.
We adjust the model by incorporating this “inconvenience”, assuming that if the firm
calls its debt, bondholders must pay transaction costs proportional to the face value of the
bond. In model terms, at the call boundary (eq. 10) the bond value is the following:
Schultz (2001) presents evidence that round-trip transactions costs for investment grade
bonds average $2.70 per $1,000 of par value. Bondholders subject to the call of a bond are
presumably faced with one-way transactions costs when they reinvest call proceeds since
cash proceeds from the call are likely to be directly deposited into one of the investor’s bank
accounts. Thus, for the one-way trip bondholders experience when reinvesting proceeds from
a called bond, we assume that transactions costs are $1.35 per $1,000 of par value.23
When transactions costs of this magnitude are incorporated in our model in addition to
capital gains taxes, the non-callable credit spread again stays constant, but the incremental
yield attributable to the make-whole call provision increases by 0.37 bp from 5.83 bp to 6.20
bp.
Survey results from Graham and Harvey (2001) make it clear that firms value financial
flexibility. While their results imply that firms keep leverage low in order to be able to
23
We impose an artificial restriction that no calls can occur within three months of the bond’s maturity
date. We do this because model-generated credit spreads decline to zero for all but the riskiest bonds as the
maturity date approaches. This is a common outcome for structural models. If the bond has a make-whole
call provision, then the likelihood of a call approaches one as long as the make-whole premium is greater than
zero. This has minimal impact on the incremental yield of a make-whole call provision in a world devoid of
imperfections. However, when we include transactions costs, the result is that these costs are imposed far
too frequently unless something like the three month barrier is applied.
25
issue debt in the future, survey results from Mann and Powers (2003b) indicate that firms
also value the flexibility to retire debt early. Specifically, they document that CFO’s value
make-whole call provisions because the call provision gives the firm ”the ability to retire 100
percent of a debt issue” without having to resort to a potentially costlier tender offer.
This cap on the price of a successful tender offer pays off in situations where a tender
offer would have otherwise occurred. Mann and Powers (2003c) find that tender offers are
primarily driven by exogenous events. For example, debt issues acquired during a merger or
acquisition may contain restrictive covenants that the surviving firm finds inconvenient and
desires to eliminate. They document that in the typical successful tender offer, the median
tendering firm pays bondholders a premium above market value of approximately $40 per
$1,000 of face value. The yield corresponding to this average tender price is approximately
We conservatively assume that all tender offers occur at a spread of 10 bp above Trea-
suries. Thus, any make-whole call provision with a premium of 10 bp or more will reduce
ex-ante incremental yield. Obviously, the greater the likelihood of situations requiring early
To estimate the likelihood of such an exogenous event, we search the transactions data in
the FISD for sales of bonds where the name of the purchaser includes the word “tender”.24
For all non-callable bonds and make-whole call bonds that mature after January 1, 1995 and
which pass the screening criteria described in the data section, we are able to identify 244
tender offers.
This number is likely to be an under-estimate of the true number of tender offers due
24
The FISD has a field denoting whether a tender or exchange offer has ever been made for each bond,
but the field is dormant and unused.
26
to data entry errors and a lack of data standardization. To estimate the degree of under-
tender offers provided by Mann and Powers (2003c). Our sample identifies 73.5% of their
confirmed tender offers. Thus, we suspect that our sample of FISD-identified tender offers
1
understates the true number by approximately 36% ( 0.735 − 1) and that the true number
should be approximately 332 tender offers. In addition, we are able to identify 13 actual calls
of bonds with make-whole call provisions, making the total number of early redemptions 345.
The total number of bond-years from which redemptions are identified is 41,631. Thus, we
estimate that redemptions occur in approximately 0.83 percent of bond-years. The median
number of bond years per bond is 5. On an annualized basis, therefore, the likelihood of
observing an early redemption is only 0.17 percent per year (1 — (1-0.0017)5 =0.0083).
With this information, we further modify the model by incorporating a Poisson arrival
process for an exogenous event that induces the firm to retire the bond early. The probability
of such an event is assumed to be constant per unit of time and independent of the remaining
maturity. If such an event arrives, the firm with a non-callable bond tenders for its bond
at the risk-free rate plus 10 bp while the firm with a make-whole call bond can call at the
make-whole call price. Note that we still assume that the firm with a make-whole call bond
can also call its bond endogenously, i.e., for economic reasons.
With an exogenous retirement requirement, imposed in addition to the two prior imper-
fections, the non-callable credit spread for the base case bond decreases slightly from 65.21
bp to 64.83 bp due to the potential windfall that a tender offer will generate.25 The windfall,
however, is capped in the case of the make-whole call bond. Thus, the incremental yield
attributable to the make-whole call provision increases by 0.40 bp from 6.20 bp to 6.60 bp.
25
For consistency, one-way transactions costs as well as capital gains taxes are imposed when a tender
occurs, moderating the benefit of the windfall.
27
6.4 Empirical Results Incorporating Imperfections into the Model
In Table 5, we present the same summary statistics as given in Table 2 for sample bonds.
gains taxes, transactions costs, and exogenous events requiring redemption. To save space,
we mention only the model-generated incremental yield, noting that after incorporating
imperfections, the incremental yield has a mean (median) value of 6.07 (5.44) bp.
Regression results using the new model-generated values are reported in Table 6. We
confine our discussion to the robust regression results presented in the second and third
specifications. As expected, estimated coefficients for the various exogenous control vari-
ables do not change significantly. Estimated coefficients for the non-callable credit spread
NC CSpm are also quite similar to Table 4 values. This is expected since the incorporated
Of greater importance are the estimated coefficients for the incremental yield attributable
to the make-whole call provision MW IYm . Coefficient estimates for this variable are no-
ticeably smaller with values of 2.393 and 2.130. In both cases, however, F-tests indicate
that estimated coefficients for MW IYm are still significantly different from one (p-values <
.0001). Even after incorporating imperfections that likely increase the cost of make-whole
call provisions, our results still suggest that the call provisions are overpriced.
7 Robustness Checks
7.1 Analysis of More Homogenous Subsamples
Despite all of the control variables used in the regression analysis, one might still criticize our
analysis by suggesting that there are unobserved factors which explain the greater offering
spread for bonds with make-whole call provisions and that these factors are simply correlated
28
with the presence of a make-whole call provision. One way to reduce the likelihood of
unobserved heterogeneity within the issuing firms is to limit our sample to bonds with
similar characteristics.
In Table 7, we replicate the second specification in Table 6 (robust OLS using model-
generated values which incorporate imperfections) on various subsamples of the data. In the
first specification in Table 7, we restrict the sample to bonds that have ratings of Baa- or
better, eliminating the low grade and unrated bonds where heteroscedasticity is greatest. In
the second specification we further eliminate bonds issued by finance or utility companies
since it is conceivable that these firms use call provisions in a different manner than do
industrial firms. In both specifications, results are similar to those presented in Table 6.
In the third specification we reduce heterogeneity between the non-callable and make-
whole call bonds by matching them such that for each make-whole call bond there is one
non-callable bond with the same rating, similar maturity, and the same industry group.
Estimated coefficients for this matched subsample are also quite similar to the results shown
in Table 6.
In the final specification in Table 7, our subsample is restricted to non-callable and make-
whole call bonds issued by firms represented by at least one of each type of bond in our
sample. Again results are similar to those presented in Table 6 and the estimated coefficient
for MW IYm is significantly different from one. To summarize, these subsample robustness
checks suggest that the greater at-issue yield of bonds with make-whole call provisions is due
to the make-whole call provision, not to other unobserved differences between non-callable
and make-whole call bonds. Thus, results still suggest that make-whole call provisions are
overpriced at origination.
29
7.2 Alternative Models
For the majority of structural models it is not sales or cash flow that is stochastic, rather,
firm value V is assumed to be stochastic. To ensure that our results are not dependent on
our most basic modeling assumption, we replace the stochastic process for ds/s in equation
(2) with
dV
= (r − α)dt + σ V dWV . (15)
V
To parameterize the firm value variant of our model we first calculate the annual volatility
of equity σ E using the past 6 months of daily stock returns. The volatility of firm value σ V
is related to σ E by
V dEt
σE = σV . (16)
E dVt
dEt
Following Eom, Helwege, and Huang (2003), we approximate dVt
using the Merton (1974)
model where,
Vt
σ E = σ V N(d1 (Kt , t)) , (17)
Et
V0 σ 2V
ln( xD(0,t) ) + (−α + 2
)t
d1 (x, t) = √ , (18)
σV t
and where D(0, t) is the present value of a risk-free zero-coupon bond maturing at t, α is
The cash flows available to service debt are assumed to be a linear function of firm value.
As before, we use a representative group of non-callable bonds and solve for an optimal
mapping of Q into α using the functional form given in equation 12. All other characteristics
Predicted spreads and more importantly incremental yields are quite similar when com-
pared to our original results. For example, with the baseline model that does not incorporate
30
imperfections, the average incremental yield using firm value as the stochastic process is 2.36
bp as compared to 2.75 bp. (results not presented in tables). In subsequent regression anal-
ysis (results not presented in tables) where NC CSpm and MW IYm are calculated using
the stochastic firm value process, results are similar in magnitude and significance to those
presented in Table 4.
of basic bond characteristics. To do this, we split the sample based on issue date, time
to maturity, and rating. We then estimate regression specification 2 from Table 6 for each
We first split the sample based on whether the bond was issued before or after 10/1/1999.
This split-date is chosen because it allocates roughly the same number of make-whole call
bonds to each subsample. Results for specification 1 show that there is no significant dif-
ference in the estimated coefficients for the the incremental yield MW IYm , suggesting that
mispricing at origination has been present across the entire time-span of the sample.
bond is more or less than 10.1 years. Again, estimated coefficients for MW IYm are not
Finally, in specification 3, we split the sample based on whether the rating of the bond is
Baa+ or better as opposed to Baa or worse. For this sample split, estimated coefficients for
MW IYm of 1.626 for highly rated bonds and 3.485 for poorly rated bonds are significantly
different from one another (p-value=0.002). The larger estimated coefficient for the poorly
rated bonds indicates that investors require significantly greater compensation than predicted
by our model when a make-whole call provision is attached to a poorly rated bond.
31
One potential explanation for this result could be our assumption that the likelihood
of an exogenous event requiring early redemption is the same for all firms. Nuttall (1999),
however, finds that the likelihood of being a takeover target for UK quoted companies is
greater for more levered and more poorly performing firms. Poorly rated bonds are also
more likely to contain restrictive covenants (Nash, Netter, and Poulsen; 2003) which, if they
become binding in the future, will provide an incentive for the firm to retire debt early. In
either case, it is possible that the likelihood of our exogenous event should increase as credit
quality deteriorates. The alternative reason for the greater observed incremental yields for
poorly rated make-whole call bonds is that investors are unneccesarily penalizing poorly
8 Conclusion
Make-whole call provisions have become quite common in corporate debt over the past
five years. The call provision’s primary benefit is that it gives the issuing firm substantial
financial flexibility without the high up-front cost of a fixed-price call provision. The lower
cost is directly attributable to the fact that the make-whole call price floats inversely with
contemporaneous risk-free interest rates. This greatly reduces the interest rate risk that is
Despite the prevalence of make-whole call provisions, we are the first to provide a model
for valuing them. In a frictionless market environment, our model predicts that the average
bond with a make-whole call provision should have a yield that is approximately 2.75 bp
greater than a comparable non-callable bond. When real-world market imperfections such
as capital gains taxes, transactions costs, and exogenous requirements to retire debt early
are taken into account, our model indicates that the incremental yield should average ap-
proximately 6.1 bp. Extensive empirical analysis of at-issue credit spread data for a large
32
sample of corporate bonds with make-whole call provisions, however, indicates that the ob-
served incremental yield is more than 11 bp. Moreover, the difference between observed and
call provisions to date have been overpriced at origination and that issuing firms have been
paying too high of a yield on their newly issued make-whole call bonds. An additional 5 bp
in yield may seem negligible, however, it is substantial when compared to the typical credit
spread at origination of 125 bp. In dollar terms, for a representative par bond with 15 years
in yield reduces offering proceeds by $2.3 million - to us a sum that should not be casually
disregarded.
Like all structural models, our’s is an abstraction from reality and incremental yields
are potentially predicted with error. We feel, however, that our model likely overestimates
what incremental yields should be, further strengthening our empirical results. One reason
why we believe this is because our underlying model is strictly a default model. In practice,
however, corporate credit spreads incorporate other factors such as liquidity risk, systematic
risk, and differential state taxation relative to Treasury securities (Elton et al.; 2001). These
other factors lend an additional component to credit spreads, ensuring that even the most
credit-worthy corporate bonds have yields that are significantly greater than risk-free yields.
For example, since 1954, Moody’s seasoned Aaa corporate bond yield has averaged 75 bp
more than the 10-year Constant Maturity Treasury yield. In this environment, the typical
make-whole call provision with a make-whole premium of 25 bp will have minimal economic
The second reason why our model might overestimate incremental yields is that in the
extended version, we have only included imperfections that generate an increase in incremen-
tal yields. Alternative imperfections, however, could conceivably have the opposite effect.
33
For example, firms might delay calls due to transactions costs incurred when calling (Mauer;
1993), concerns about wealth transfers resulting from temporary capital structure changes
(Longstaff and Tuckman; 1994), or simply because a suboptimal call policy is employed
(King and Mauer; 2000). Anything which delays calls beyond the point predicted by our
The final reason why model-generated incremental yields might be too high is because we
have been conservative in our assumptions regarding the three incorporated imperfections.
For example, we assume that the marginal investor is taxed. This is highly debatable when
the investment is a corporate bond. In addition, we assume a worst-case scenario when firms
are exogenously required to tender for non-callable debt. Thus, the additional incremental
It is unclear whether this perceived pricing anomaly will continue. Longstaff (1992)
for example, shows that there has been persistent mispricing of fixed-price call options on
older Treasury securities, despite the apparent existence of arbitrage opportunities. For
make-whole call provisions we see little opportunity for arbitrage opportunities due to the
obvious mechanism that will drive down the at-issue incremental yield of make-whole call
provisions.
Note that we test our model only against at-issue bond data. Primarily, this is be-
cause at-issue data is significantly cleaner, verifiable, and easily worked with than the sparse
transactions data available for corporate bonds. An interesting extension for future research,
however, would be to apply our model to transactions data in a manner similar to that done
by Duffee (1998) for bonds with fixed-price call provisions. This would enable us to deter-
mine whether the perceived mispricing persists in the after-market. In addition, analysis of
how make-whole call bond yields evolve relative to non-callable bond yields as characteristics
34
of firms, the bond market, and the macroeconomy change would improve our understanding
9 Appendix
9.1 Valuation of the unlevered firm
The value of the unlevered firm V is given as the solution to the following PDE
σ 2r r σ 2 s2 √
Vrr + s Vss + ρσ s σ r s rVrs
2 2 (19)
∗
+ κr (r − r)Vr + (r − α)Vs + s − p − rV = 0, V ≥ 0.
The boundary condition V ≥ 0 reflects the firm’s option to shut down its operations as
Given the value of the short-term interest rate r, and the price level s, the value of equity
E(s, r, t) can be determined by maximizing the expected value of equity, over all possible
At the debt maturity date T , the value of the firm’s equity is the greater of zero and the
difference between the value of the firm’s assets and the par value,
Any time prior to maturity, t < T, the value of equity E is given as the solution to the
following PDE:
35
σ 2r r σ 2 s2 √
Err + s Ess + ρσ s σ r s rErs + κr (r∗ − r)Er + (r − α)Es +
2 2 (22)
+ Et + s − p − c − rE = 0, E ≥ 0
with additional free boundary conditions that characterize the boundaries where debt is
called and where the firm defaults. The call boundary (if applicable) should satisfy
36
References
[1] Acharya, Viral V., and Jennifer Carpenter, 2002, Corporate bond valuation and hedging
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41
The columns display the nominal dollar amount of corporate debt issued in the U.S. per year.
Included issues have the following characteristics: maturity of at least one year, denominated in
U.S. dollars, offering amount greater than $25 million, fixed semi-annual coupon, not asset-backed,
not putable, without a sinking fund, not a Yankee bond, not a Medium Term Note, not part of a unit
offering, and listed as a corporate debenture. Note that the 2002 data stops at 10/01/2002.
42
Plot points show the model-generated incremental yield attributable to the make-whole call
provision as a function of the make-whole premium. All other parameters for the model are held
fixed at base case values.
43
Table 1
Panel A: Issuing Firm Characteristics.
Means (medians) for issuing firm characteristics. We allow one observation per firm, per bond
type, per year. Columns two and three present results for the entire universe of straight bond and
make-whole call bond issuers screened from the FISD. Column four displays p-values for a T-test
and a Wilcoxon Rank-Sum test comparing straight issuers to make-whole issuers from columns two
and three. Columns five and six present results for the subset of bond issuers where we were able to
calculate a model-generated credit spread. Data definitions: Sales: total firm sales, EBITDA/MKT:
earnings before interest, taxes, and depreciation divided by market value of firm, EBITDA/AT:
EBITDA divided by total assets, Q: (total assets – book equity + market equity) divided by total
assets, Book Leverage: long-term debt divided by total assets, Sales Growth: 10 year average annual
sales growth, σ Sales Growth: standard deviation of 10 year annual sales growth, Equity Volatility:
standard deviation of daily excess stock return for the prior 6 months.
Initial Sample Final Sample
Straight Make-whole T-test Straight Make-whole
(Rank-Sum)
Sales $10,111 $7,712 .0016 $10,988 $8,797
($3,758) ($3,145) (.0049) ($4,683) ($4,415)
EBITDA/MKT 7.4% 8.3% .0001 8.1% 8.9%
(7.7%) (8.2%) (.0001) (8.5%) (8.8%)
EBITDA/AT 12.1% 13.5% .0009 12.9% 14.0%
(11.6%) (13.1%) (.0001) (13.0%) (13.1%)
Q 1.63 1.76 .0185 1.58 1.58
(1.32) (1.41) (.0001) (1.34) (1.37)
Book Leverage 28.1% 30.1% .0090 23.2% 31.4%
(26.4%) (29.3%) (.0004) (24.9%) (30.2%)
Sales Growth 13.5% 16.3% .0195 10.6% 11.9%
(9.3%) (9.3%) (.5278) (8.6%) (9.2%)
σ Sales Growth 15.4% 16.6% .0685 12.0% 12.8%
(11.8%) (11.5%) (.9804) (11.0%) (11.5%)
Equity 0.020 0.022 .0000 0.019 0.022
Volatility (0.017) (0.020) (.0000) (0.017) (0.021)
# of Obs. 966 1083 520 435
44
Panel B: Bond Characteristics.
Data definitions: Rating: ordinalized bond rating (AAA = 1, AA+ = 2, etc.), Maturity: years to
maturity, Offering Amount: total face value in millions of nominal dollars, Offering Spread: actual
yield-to-maturity at issue minus the equivalent maturity Constant Maturity Treasury yield.
Initial Sample T-test Final Sample
Straight Make-whole Rank-Sum Straight Make-whole
Rating 7.0 8.3 .0001 7.0 8.5
(7.0) (9.0) (.0001) (7.0) (9.0)
Maturity 10.7 13.0 .0001 11.1 12.2
(9.0) (10.0) (.0001) (10.0) (10.0)
Offering $403 $392 .4909 $336 $365
Amount ($250) ($300) (.0001) ($244) (281)
Offering Spread 117 bp 179 bp .0001 108 bp 180 bp
(88 bp) (155 bp) (.0001) (88 bp) (163 bp)
# of Obs. 1,612 1,583 775 734
45
Table 2
Model-Generated Credit Spreads
Predicted Spread is the model-generated yield-to-maturity minus the model-generated risk-free rate.
For make-whole call bonds, Predicted Spread incorporates the inclusion of a make-whole call
provision. Prediction Error is Predicted Spread minus observed Offering Spread and σ Prediction
Error is the associated standard deviation. Relative Prediction Error is Prediction Error divided by
observed Offering Spread and σ Relative Prediction Error is the associated standard deviation.
Both signed values for errors and absolute values are presented. Incremental Yield is reported only
for make-whole call bonds and is the Predicted Spread for the make-whole call bond minus the
Predicted Spread for a straight bond that, with the exception of the make-whole call provision, is
equivalent in all respects.
Non-callable Make-whole
Signed Absolute Signed Absolute
Value Value Value Value
Predicted Spread 81 bp 145 bp
(38 bp) (114 bp)
Prediction Error -26 bp 81 bp -35 bp 104 bp
(-44 bp) (67 bp) (-48 bp) (89 bp)
σ Prediction Error 98 bp 61 bp 127 bp 80 bp
46
Table 3
Comparative Statics
The model parameters for the base case bond are as follows: make-whole premium (Premium) = 0
bp for base case non-callable bond and 24 bp for base case make-whole call bond, Maturity = 10
years, long-term debt divided by total assets (Leverage) = 18.5%, payout rate of firm (Alpha) =
4.56%, 10 year historical variance of annual sales (Sales Volatility) = 11.4%, yield of model derived
10 year risk-free note (Yield Curve Level) = 5.64%, correlation of stochastic processes for risk-free
rate and cash flows (Stochastic Correlation) = 0.027. The model-generated Credit Spread for the
base case non-callable bond is 65.21 bp and the Incremental Yield of the equivalent make-whole
call bond is 3.89 bp. Each row of the table reports the Credit Spread and Incremental Yield as one
of the parameters, for example Premium, is varied below and then above the base case value. The
low and high values for the respective parameters roughly correspond to 25th and 75th percentile
sample values.
Parameter low value Credit Incremental
high value Spread Yield
Premium: 18 bp 65.21 bp 2.33 bp
30 bp 65.21 bp 5.44 bp
47
Table 4
Empirically Observed Credit Spreads Versus "Pure" Model-Generated Values
The dependent variable is the bond's actual credit spread at issue. Independent variables are as follows. NC_CSpm
is the model-generated credit spread for a non-callable bond. For make-whole call bonds, it is the credit spread of
an equivalent straight bond. MW is coded one for bonds with a make-whole call provision, zero otherwise.
MW_IYm is the model generated make-whole call provision incremental yield and is set to zero for straight bonds.
Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield. Rule 144a is coded one for privately
issued bonds, zero otherwise. Finance and Utility are coded one for financial services and utility firms,
respectively, zero otherwise. Residual Rating is the difference between actual ordinal rating of the bond and a
predicted rating obtained via an ordered logit regression (see text for details). Not Rated is coded one for unrated
bonds, zero otherwise. First Bond is coded one when the observation represents the first bond issue for the firm,
zero otherwise. Senior is coded one if the bond is denoted senior or senior-secured, zero otherwise. Equity
Volatility is standard deviation of the firm's excess stock returns for the 183 days prior to the offering. Specification
1 is OLS while 2 and 3 are robust OLS (weighted least squares is used to limit impact of outliers). Below each
coefficient estimate is the t-statistic (for specification 1 the t statistics are calculated using White standard errors.)
Significance at the 10%, 5% and 1% levels is denoted by *, **, ***, respectively.
Spec. 1 Spec. 2 Spec. 3
Constant 0.390 -0.556 -0.075
(1.34) (2.72)** (0.40)
NC_CSpm 0.257 0.184 0.184
(12.22)*** (18.16)*** (19.76)***
MW_IYm 6.219 4.359 3.866
(6.07)*** (8.46)*** (8.19)***
Baa_CMT_Sp 0.731 0.684 0.509
(28.80)*** (27.48)*** (20.98)***
Residual Rating 0.153 0.126 0.129
(17.07)*** (20.62)*** (23.05)***
Not Rated -0.610 -0.750 -0.443
(4.90)*** (13.99)*** (8.48)***
Rule 144A 0.467 0.385 0.329
(7.76)*** (11.57)*** (10.76)***
Finance -0.018 0.081 0.094
(0.41) (2.81)*** (3.54)***
Utility -0.020 0.018 0.104
(0.30) (0.40) (2.52)**
Log Maturity 0.046 0.107 0.135
(2.01)** (6.08)*** (8.32)***
Log Offering Amt -0.047 -0.006 -0.062
(2.10)** (0.35) (4.14)***
First Bond 0.134 0.144 0.097
(2.74)*** (4.79)*** (3.52)***
Senior -0.492 -0.080 -0.149
(4.02)*** (1.56) (3.18)***
Equity Volatility 30.031
(19.05)***
# of OBS 1339 1339 1339
Adj. R2 .6169 .5647 .6458
48
Table 5
Model-Generated Credit Spreads Incorporating Imperfections
Predicted Spread is the model-generated yield-to-maturity minus the model-generated risk-free rate.
For make-whole call bonds, Predicted Spread incorporates the inclusion of a make-whole call
provision. Prediction Error is Predicted Spread minus observed Offering Spread and σ Prediction
Error is the associated standard deviation. Relative Prediction Error is Prediction Error divided by
observed Offering Spread and σ Relative Prediction Error is the associated standard deviation.
Both signed values for errors and absolute values are presented. Incremental Yield is reported only
for make-whole call bonds and is the Predicted Spread for the make-whole call bond minus the
Predicted Spread for a straight bond that, with the exception of the make-whole call provision, is
equivalent in all respects.
Straight Make-whole
Signed Absolute Signed Absolute
Value Value Value Value
Predicted Spread 81 bp 147 bp
(37 bp) (117 bp)
Prediction Error -27 bp 81 bp -33 bp 102 bp
(-44 bp) (67 bp) (-45 bp) (86 bp)
σ Prediction Error 97 bp 61 bp 125 bp 80 bp
49
Table 6
Empirically Observed Credit Spreads Versus Model-Generated Values with Imperfections
The dependent variable is the bond's actual credit spread at issue. Independent variables are as follows. NC_CSpm
is the model-generated credit spread for a non-callable bond. For make-whole call bonds, it is the credit spread of
an equivalent straight bond. MW is coded one for bonds with a make-whole call provision, zero otherwise.
MW_IYm is the model generated make-whole call provision incremental yield and is set to zero for straight bonds.
Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield. Rule 144a is coded one for privately
issued bonds, zero otherwise. Finance and Utility are coded one for financial services and utility firms respectively,
zero otherwise. Residual Rating is the difference between actual ordinal rating of the bond and a predicted rating
obtained via an ordered logit regression (see text for details). Not Rated is coded one for unrated bonds, zero
otherwise. First Bond is coded one when the observation represents the first bond issue for the firm, zero
otherwise. Senior is coded one if the bond is denoted senior or senior-secured, zero otherwise. Equity Volatility is
standard deviation of the firm's excess stock returns for the 183 days prior to the offering. Specification 1 is OLS
while 2 and 3 are robust OLS (weighted least squares is used to limit impact of outliers). Below each coefficient
estimate is the t-statistic (for specifications 1 the t-statistic is calculated using White standard errors.) Significance
at the 10%, 5% and 1% levels is denoted by *, **, ***, respectively.
Spec. 1 Spec. 2 Spec 3.
Constant 0.331 -0.582 -0.124
(1.13) (2.83)*** (0.66)
NC_CSpm 0.242 0.176 0.176
(11.67)*** (17.50)*** (19.15)***
MW_IYm 3.239 2.393 2.130
(5.85)*** (8.22)*** (8.01)***
Baa_CMT_Sp 0.734 0.682 0.507
(18.85)*** (27.12)*** (20.75)***
Residual Rating 0.158 0.129 0.131
(17.62)*** (21.23)*** (23.64)***
Not Rated -0.587 -0.738 -0.433
(4.65)*** (13.63)*** (8.24)***
Rule 144A 0.476 0.386 0.328
(7.88)*** (11.59)*** (10.75)***
Finance -0.025 0.076 0.089
(0.58) (2.60)*** (3.36)***
Utility -0.036 0.005 0.090
(0.55) (0.10) (2.17)**
Log Maturity 0.065 0.119 0.146
(2.80)*** (6.66)*** (8.91)***
Log Offering Amt -0.044 -0.004 -0.059
(1.99)** (0.26) (3.93)***
First Bond 0.146 0.148 0.101
(3.04)*** (4.89)*** (3.64)***
Senior -0.505 -0.091 -0.159
(4.12)*** (1.76)* (3.39)***
Equity Volatility 30.07
(19.03)***
# of OBS 1339 1339 1339
Adj. R2 .6129 .5618 .6421
50
Table 7
Robustness Checks for Empirically Observed Credit Spreads
The dependent variable is the bond's actual credit spread at issue. Independent variables are as follows.
NC_CSpm is the model-generated credit spread for a non-callable bond. For make-whole call bonds, it is the
credit spread of an equivalent straight bond. MW is coded one for bonds with a make-whole call provision,
zero otherwise. MW_IYm is the model generated make-whole call provision incremental yield and is set to
zero for straight bonds. Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield. Rule
144a is coded one for privately issued bonds, zero otherwise. Finance and Utility are coded one for financial
services and utility firms, respectively, zero otherwise. Residual Rating is the difference between actual
ordinal rating of the bond and a predicted rating obtained via an ordered logit regression (see text for details).
Not Rated is coded one for unrated bonds, zero otherwise. First Bond is coded one when the observation
represents the first bond issue for the firm, zero otherwise. Senior is coded one if the bond is denoted senior
or senior-secured, zero otherwise. All specifications are robust OLS (weighted least squares is used to limit
impact of outliers). The subsamples for each regression are as follows: specification 1: rating of Baa- or
better, specification 2: Rating of Baa- or better and excluding bonds issued by finance or utility companies,
specification 3: matched subset of the sample where make-whole and straight bonds have been matched on
the basis of rating, maturity and industry group, specification 4: bonds issued by firms that are represented by
at least one straight bonds and at least one make-whole call bond in the sample. Below each coefficient
estimate is the t-statistic. Significance at the 10%, 5% and 1% levels is denoted by *, **, ***, respectively.
Spec. 1 Spec. 2 Spec. 3 Spec. 4
Constant -1.043 -0.118 -0.222 0.659
(5.79)*** (0.30) (0.79) (2.27)**
NC_CSpm 0.133 0.152 0.185 0.145
(13.53)*** (11.79)*** (14.45)*** (11.17)***
MW_IYm 2.092 2.750 2.462 2.009
(7.57)*** (7.95)*** (7.47)*** (5.42)***
Baa_CMT_Sp 0.699 0.643 0.693 0.613
(31.00)*** (24.16)*** (22.11)*** (20.19)***
Residual Rating 0.094 0.091 0.134 0.093
(15.95)*** (13.33)*** (17.89)*** (12.45)***
Not Rated -0.673
(9.34)***
Rule 144A 0.286 0.275 0.363 0.187
(8.93)*** (7.67)*** (9.75)*** (4.58)***
Finance 0.153 0.043 0.140
(5.90)*** (0.93) (2.65)**
Utility -0.037 -0.109 0.098
(0.86) (1.46) (1.34)
Log Maturity 0.152 0.150 0.112 0.145
(9.92)*** (8.68)*** (5.08)*** (7.14)***
Log Offering Amt 0.007 -0.004 -0.027 0.034
(0.52) (0.21) (1.26) (1.60)
First Bond 0.140 0.169 0.184 0.127
(4.96)*** (4.64)*** (5.02)*** (2.19)**
Senior 0.105 -0.601 -0.202 -1.787
(1.98)** (1.84)* (2.42)** (12.33)***
# of OBS 1126 815 779 548
Adj. R2 .6184 .6046 .5643 .5178
51
Table 8
Split Sample Comparisons
The dependent variable is the bond's actual credit spread at issue. Independent variables are as follows. NC_CSpm
is the model-generated credit spread for a non-callable bond. For make-whole call bonds, it is the credit spread of
an equivalent straight bond. MW is coded one for bonds with a make-whole call provision, zero otherwise. MW_IYm
is the model generated make-whole call provision incremental yield and is set to zero for straight bonds.
Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield. Rule 144a is coded one for privately
issued bonds, zero otherwise. Finance and Utility are coded one for financial services and utility firms,
respectively, zero otherwise. Residual Rating is the difference between actual ordinal rating of the bond and a
predicted rating obtained via an ordered logit regression (see text for details). Not Rated is coded one for unrated
bonds, zero otherwise. First Bond is coded one when the observation represents the first bond issue for the firm,
zero otherwise. Senior is coded one if the bond is denoted senior or senior-secured, zero otherwise. All
specifications are robust OLS (weighted least squares is used to limit impact of outliers). For specification 1, the
sample is split into bonds issued before versus after 10/1/1999. For specification 2, the sample is split into bonds
with maturity less than versus more than 10.1 years. For specification 3, the sample is split into bonds with ratings
of Baa+ or better versus Baa or worse. Below each coefficient estimate is the t-statistic Significance at the 10%, 5%
and 1% levels is denoted by *, **, ***, respectively.
Spec. 1 Spec. 2 Spec. 3
Early Late Short Mat. Long Mat. Good Rating Poor Rating
Constant -0.668 3.690 0.244 -1.064 -1.031 0.998
(3.55)*** (6.32)*** (0.62) (4.28)*** (5.57)*** (1.73)*
NC_CSpm 0.136 0.217 0.166 0.177 0.135 0.290
(14.39)*** (9.95)*** (9.45)*** (14.16)*** (11.52)*** (10.62)***
MW_IYm 2.137 1.828 2.209 2.697 1.626 3.485
(7.33)*** (3.03)*** (5.09)*** (6.03)*** (5.52)*** (5.80)***
Baa_CMT_Sp 0.665 0.054 0.707 0.674 0.673 0.860
(24.09)*** (0.73) (16.79)*** (21.16)*** (28.16)*** (14.80)***
Residual Rating 0.116 0.180 0.150 0.115 0.093 0.225
(22.23)*** (10.94)*** (13.76)*** (15.82)*** (12.41)*** (9.39)***
Not Rated -0.551 -0.523 -0.982 -0.491
(2.78)*** (6.12)*** (10.34)*** (7.54)***
Rule 144A 0.354 0.469 0.478 0.314 0.253 0.491
(11.18)*** (6.68)*** (8.55)*** (7.60)*** (6.46)*** (7.27)***
Finance 0.085 0.071 0.080 0.090 0.170 -0.160
(3.35)*** (0.98) (1.70)* (2.35)** (6.25)*** (1.85)*
Utility 0.022 0.024 -0.106 0.057 0.029 -0.092
(0.45) (0.27) (1.28) (1.07) (0.63) (0.88)
Log Maturity 0.135 0.182 0.202 0.124 0.159 -0.001
(8.92)*** (3.90)*** (3.10)*** (4.29)*** (10.02)*** (0.03)
Log Offering Amt -0.007 -0.189 -0.035 0.027 0.005 -0.103
(0.47) (4.58)*** (1.23) (1.35) (0.72) (2.12)**
First Bond 0.162 0.031 0.107 0.147 0.113 0.202
(5.84)*** (0.43) (1.90)* (4.16)*** (3.46)*** (3.01)***
Senior -0.000 -0.303 -0.684 -0.016 0.147 -0.843
(0.00) (2.22)** (4.43)*** (0.30) (2.92)*** (6.92)***
# of OBS 887 452 539 800 810 458
Adj. R2 .5821 .4517 .5532 .6073 .6361 .5717
52