Credit Risk and the Life Cycle of Callable Bonds: Implications for Real Corporate Decisions

Abstract

We show that callable bonds have both higher yields and lower market prices than matched non-callable bonds of the same issuer-time, reflecting the value of call features to issuers and investors. This “value of callability” as well as the inclusion and the exercise of call rights are jointly determined by issuer credit quality. Our agency-based theoretical and empirical analyses further show that callability reduces debt overhang in corporate mergers. Our results help explain the value and increasing prevalence of callable bonds in credit markets.