Callable Bonds: A Risk-Reducing Signalling Mechanism

The theory of financial economics has failed to distinguish advantages of callable bonds from those of short-term debt. This paper shows that either type of borrowing can signal a firm's better prospects but that short-term debt does so at the cost of weakened risk-sharing with capital markets. By issuing either equity or long-term, non-callable debt, a firm with poor investment opportunities will not pool its prospects with those of a better firm. But equity produces superior risk-sharing. Perhaps this explains the almr,ost complete absence of long-term, non-callable bonds from observed corporate capital structures. FINANCIAL THEORY HAS FOUND only moderate success in explaining the routine inclusion of call provisions among the covenants of corporate bonds. In the absence of market imperfections or incompleteness, the incremental compensation promised to bondholders should exactly offset the value of the call provision retained by equityholders. Indifference should obtain.1 Nevertheless, it is hard to accept indifference as an explanation, given the near universality of call provisions in corporate bond contracts. In this paper, we argue that, in the presence of asymmetric information about investment quality, corporate managers can signal their firm's better prospects by issuing bonds that include call provisions. Our major result shows that this signalling mechanism can be more attractive to risk-averse managers than would be the choice of short-term debt (which could also serve to signal). Furthermore, we demonstrate that non-callable corporate debt is a dominated security. That is, both it and equity signal "Bad News," but equity provides risk-sharing. This finding helps to explain the relative absence of long-term, non-callable debt from corporate financial markets. Previous attempts to explain the prevalence of call provisions in corporate bond contracts fall into four categories. Two categories involve pure wealth transfers from bondholders to stockholders. In these constant sum environments, a gain to one group constitutes a loss to the other. In the first category, managers possess private information with regard to future interest rate movements. Issuing callable bonds will capture gains for stockholders when anticipated drops