Doomsday call option

What is a Doomsday Call?

A doomsday call, also known as a "Canadian call," is a unique financial option that provides the issuer with a strategic tool to mitigate interest rate risk by allowing them to redeem a bond prematurely. When the issuer exercises the doomsday call option, it leads to a decrease in the bond’s yield. This reduction occurs because the remaining term of the bond is shortened, resulting in a decreased total interest payable to bondholders. The term "Doomsday call" is often synonymous with a "Canadian call" since it is frequently included in bonds issued by Canadian corporations as a protective measure against interest rate fluctuations.

Doomsday Call Explained

The doomsday call option is an intriguing financial instrument that is seldom exercised within the market. Its utility becomes most apparent in scenarios where interest rates decline. When this situation arises, the issuer may choose to utilize the doomsday call option to retire the existing bond prematurely, enabling them to issue a new bond at more favorable, lower interest rates. This maneuver has a positive impact on the issuer, as they can reduce their borrowing costs.

Despite its somewhat ominous name, the term "doomsday call" reflects the potential risk faced by investors. If the issuer decides to exercise this option, it means that bondholders might lose out on a higher coupon rate. However, what sets bonds with embedded "doomsday call" options apart is the predetermined compensation offered to bondholders if the call option is executed. This pre-determined compensation serves as a protective measure for investors.

Typically, the terms of a doomsday call option specify the repayment amount, which can be based on either the spread over the yield of government bonds or the face value, depending on which value is higher. This structure ensures that bondholders have a clear understanding of the compensation they will receive if the issuer chooses to exercise the doomsday call option, thus minimizing uncertainty and safeguarding their investment.

How Doomsday Call Options Work?

Doomsday call options, while infrequently exercised by bond issuers, serve as an intriguing financial tool with underlying dynamics that favor the issuer. In most cases, it is advantageous for the issuer to allow the bond to run its course until maturity. However, there are scenarios, primarily involving significant decreases in interest rates, where it becomes beneficial for the issuer to employ the doomsday call option. This strategic move enables the issuer to retire the existing bond early and issue new bonds at a lower, more favorable interest rate, effectively reducing their borrowing costs.

When the doomsday call is executed, the issuer repays the bond’s principal amount and the accrued interest, all prior to the bond’s originally scheduled maturity date. This unique provision typically guarantees that the price paid for the bond creates a specific yield for the bondholder, reducing risk since it accelerates the repayment of the principal. The somewhat ominous name, "doomsday call," is derived from the potential downside faced by bondholders. If the issuer chooses to exercise this option, bondholders risk losing out on the higher coupon rate initially offered by the bond. However, from the issuer’s perspective, the name carries positive connotations as it signifies an opportunity to lower their cost of borrowing money.

A significant aspect of the doomsday call option is the protection it offers to bondholders. The provision clearly specifies what the investor will receive if the issuer decides to exercise this option. This specification typically dictates that the bond will be called at a fixed and predetermined amount. The predetermined amount is determined as either a specific spread over the yield of government bonds or the bond’s par value, depending on which of the two values is higher.

Interestingly, the origin of the term "Doomsday Call" is intertwined with the history of the company that pioneered this feature. According to financial industry lore, the provision had its inception when Domtar, a Canadian manufacturer of paper products, introduced bonds with this unique feature back in 1987. Over time, the option evolved and acquired the moniker "doomsday call" or, for those who found the name too morbid, it was also referred to as a "Canada call."

Pros and Cons of Doomsday Call Options

Pros

1. Risk Mitigation. Doomsday call options allow bond issuers to protect themselves against interest rate risk. In a declining interest rate environment, exercising the option can reduce borrowing costs, providing financial security.

2. Lower Borrowing Costs. When interest rates decrease significantly, exercising the doomsday call option enables the issuer to issue new bonds at lower interest rates. This can substantially reduce the issuer’s cost of borrowing money.

3. Clear Terms. The terms of the doomsday call option typically specify a predetermined amount that bondholders will receive if the option is exercised. This clarity reduces uncertainty and provides protection to bondholders.

4. Issuer’s Advantage. From the issuer’s perspective, the option is advantageous as it offers flexibility and cost-saving opportunities.

Cons

1. Loss of Higher Coupon Rates. Bondholders run the risk of losing out on higher coupon rates if the issuer exercises the doomsday call option. This can be a significant drawback for investors seeking income from their investments.

2. Limited Yield Potential. Bondholders may have limited yield potential when the option is exercised, especially if the predetermined amount paid upon exercise is less favorable than the original coupon rate.

3. Market Rarity. Doomsday call options are rarely exercised in the market. This rarity might make them less appealing to investors and limit their overall utility.

4. Early Principal Repayment. The accelerated repayment of the bond’s principal, which occurs when the option is exercised, can affect the bondholder’s investment strategy and might not align with their intended investment horizon.

Example of a Doomsday Call Option

An example of a Doomsday Call Option in a bond issue is the Manulife Financial Corporation’s bond with a 7.768% coupon rate and maturity date of April 8, 2019, denominated in Canadian Dollars (CAD). In this scenario, the bond issuer, Manulife Financial Corporation, embedded a doomsday call provision in the bond’s terms.

Let’s explore how the doomsday call option might work in this particular bond:

Suppose that, after the issuance of this bond, there is a significant decline in interest rates in the market. Manulife Financial Corporation, as the issuer, may decide to exercise the doomsday call option. By doing so, they can retire this bond early, before its scheduled maturity date. This move allows them to issue a new bond at a lower interest rate, effectively reducing their cost of borrowing money.

For bondholders, the doomsday call option carries a potential disadvantage. If the issuer chooses to exercise this option, investors who hold this bond may receive a predetermined amount specified in the bond’s terms, which is typically based on either a specific spread over the yield of government bonds or the bond’s face value (par value), depending on which value is higher. This predetermined amount might be less favorable than the original 7.768% coupon rate, resulting in a potential loss of income for bondholders.

In this example, the doomsday call option provides Manulife Financial Corporation with the flexibility to adapt to changing interest rate conditions while potentially saving on borrowing costs. On the other hand, bondholders may face the risk of losing out on the higher coupon rate if the issuer exercises the doomsday call. Therefore, the decision to invest in such a bond should take into account these potential advantages and drawbacks.