Make-whole Call Provisions on the HP 19BII

In recent years, bond issuers have changed from the traditional call schedule to a “make-whole” type of call. Generally, this is good for investors as it makes it less likely that high interest bonds will be called. If it is called, then they are “made whole” because they are paid the present value of the remaining cash flows. In a traditional call, investors would receive only the face value and, perhaps, a small call premium. In most cases, investors will be better off with a make-whole call.

For issuing firms the make-whole call provision provides some financial flexibility. For example, it may be that the covenants (restrictions on the issuer) are somewhat onerous and the issuer may wish to get out from under them, or there may be a change of control. The make-whole call allows refunding without a call premium being paid, or waiting until the next call date specified in the bond’s indenture.

A make-whole call provision means that the bond can be called at any time (on short notice – generally 30 or so days), and that the issuer will pay the present value of the remaining cash flows to investors. Importantly, this will be different than the current price of the bond because the discount rate is different than the recent yield to maturity. Specifically, the discount rate that is used to determine the present value is spelled out in the indenture and will be equal to the rate on a comparable Treasury security plus some spread that is also given in the indenture. The spread is fixed at issuance (usually 15 to 50 basis points, depending on credit rating and term to maturity), though the “Comparable Treasury Issue” can change. The Treasury security that is used will be selected by an independent investment banking firm at the time of the call.

In this tutorial, we will use three different methods to calculate the make-whole price at which the bond would be called. Specifically, we will use the PV and NPV functions as well as the BOND menu of the HP 19BII financial calculator.

Example of a Bond with a Make-Whole Call Provision

In late 2010, PPG Industries issued a bond that matures on 15 November 2040. The bond pays interest semiannually with a coupon rate of 5.50% per year (on 15 May and 15 November). You can see the details of this issue here. The indenture states that “optional redemption” will be on a make-whole basis at a spread of 25 bps over the comparable Treasury.

On 28 October 2014 the bond traded at a price of 117.95 (\$1,179.50), though we will pretend that the trade took place on 15 November 2014 so that we do not need to worry about valuing the bond between coupon payment dates.

On 13 November 2014, a comparable Treasury bond (the 4.25%’s of 2040) was trading at 122.7969. We will again assume that this quote was from 15 November 2014. The yield on this security was 2.98%. Therefore, the yield that will be used to calculate the present value of the remaining payments is 2.98% + 25bps = 3.23%.

With these minor simplifications, we will now determine the call price of the PPG 5.5’s of 2040. To do so, we need to calculate the present value of the remaining cash flows at the appropriate discount rate. There are 51 remaining interest payments of \$27.50 each, plus one payment of \$1,027.50 (return of principal + last interest payment). On the HP 19BII there are three ways to do this calculation. The image below shows the timeline for the cash flows:

Using the HP 19BII Time Value of Money Keys

Because we need to calculate the present value of the remaining cash flows, the easiest way to solve the problem is by using the TVM keys. If your calculator isn’t on the TVM menu, then select FIN from the main menu and then TVM to get there. Since there are 52 payments remaining, enter 52 for N, 1.615 (=3.23/2) for I%YR, 27.50 for PMT, and 1000 for FV. Remember that we are using semiannual compounding, so the interest rate must be divided by 2. Now simply press the PV key to get the answer. You should get \$1,397.28. Note that this is slightly different than I got in my Excel tutorial (\$1,396.54) because I rounded the interest rate for this one.

Using the HP 19BII NPV Function

You can also use the NPV function and the cash flows list in the CFLO menu. The number of remaining cash flows exceeds the available memory in the calculator. However, there is a shortcut that I have discussed elsewhere. Any cash flow that repeats can be entered into FLOW(x) where x is the number of the cash flow, and then we enter the number of times that it repeats by using the #TIMES(x) prompt. We will use that trick here to minimize the amount of data entry required.

Go to the CFLO menu and clear the cash flow registers by pressing SHIFT INPUT. Now, type 0 and press INPUT to enter 0 for FLOW(0). We set this to zero because we don’t really want the net present value, just the regular present value. Next, for FLOW(1) type 27.50 and press INPUT to enter the first cash flow. Because this cash flow will be repeated 51 times (see the timeline above) we now type 51 for #TIMES(1) and press INPUT. Finally, type 1027.50 INPUT for the last cash flow and leave #TIMES(2) set to the default of 1 by pressing INPUT.

Now that all of the cash flows are entered, simply press EXIT CALC and then enter the interest rate (1.615) into the I% key. Finally, press NPV to get the net present value. As before, your answer should be \$1,397.28.

Using the 19BII BOND Menu

In the bond valuation tutorial, we saw that we could use the BOND menu to find the value of a bond using actual dates, as opposed to the number of periods. We can do that here as well. Start by pressing EXIT repeatedly until you get to the main menu, and then FIN BOND to get into the BOND menu.

As before, we will assume that the settlement date was 15 November 2014, so type 11.152014 SETT. Next, type 11.152040 MAT for the maturity date. The coupon rate is 5.5%, so type 5.5 CPN% (the calculator will adjust this to semiannual for you). Type 100 CALL to be sure that it doesn’t contain anything else, that the day-count basis is set to 30/360, and that the payment frequency is semiannual. If they aren’t, you can press TYPE and change those settings. Finally, press MORE and then type 3.23 YLD% (again, the calculator will adjust this annual yield to semiannual for you).

That is all of the data entry, so press PRICE. You should see that the value of the bond is 139.72826, which is \$1,397.28. This is exactly the same result as we got with the other two methods. The advantage of using the BOND menu is that we can use any dates, so we don’t have to be on a payment date.

Conclusion

Note that whichever way you choose to do it, you get a call price of \$1,397.28, which is \$217.78 above the current price of the bond. Obviously, PPG is unlikely to call the bond under these circumstances. If you wish, you can download the spreadsheet that I created for my Excel tutorial so that you can more clearly see how this works. Just remember that the answer in the spreadsheet will be slightly different because I rounded the numbers for this tutorial. The spreadsheet is more accurate.