Credit risk, debt overhang, and the life cycle of callable bonds
Bo Becker, Murillo Campello, Viktor Thell, Dong Yan
Review of Finance, Volume 28, Issue 3, May 2024, Pages 945–985, https://doi.org/10.1093/rof/rfae001
In this paper, we propose that callable bonds may reduce the debt overhang otherwise created by corporate leverage. Connecting to theory, notably Bodie and Taggart (1978) and Diamond and He (2014), about how contracts with options that cap payout to bondholders and limit the upside, we test several predictions regarding issuance of callable bonds, how they are priced, and how investment responds to shocks for firms with different capital structures.
Our empirical findings include a large average yield premium for call features of 27 bps, estimated with issuer-period fixed effects (i.e., identified off the difference in yield-to-maturity between bonds with and without call features issued by the same firm at approximately the same time). We also find that secondary market prices for callable bonds have a virtual “ceiling” – very few bonds trade above the call price (often 100-103% of par). There is a “missing mass” of high prices. We also show that in acquisitions, targets’ debt creates debt overhang (discouraging deals), and callable debt can mitigate this debt overhang. Several additional findings are consistent with the role of call features in reducing debt overhang for corporate investment.
There are several implications of our findings. From a capital structure point of view, the inclusion of call features is an important decision – it creates a trade-off between lower yields of non-callable bonds (we estimate a shadow cost of 27 bps for call features on average, 38 for high-yield firms) and the reduced debt overhang associated with callable bonds. From an M&A point of view, the fact that large debt overhang may exist for non-callable debt may be an important consideration for acquirers. From a fixed-income investor point of view, while the yield is higher, the effective duration is lower on callable bonds (and stochastic), and the potential upside is capped. Finally, from a business cycle perspective, the fact that a lot of bond debt (as well as most bank debt) is callable reduces the extent to which debt overhang depresses investment, perhaps creating better business cycle dynamics when much debt is callable.