Call Policies with Flotation Costs: A Dog Chasing Its Tail (Revised: 22-95)

This paper presents a characterization of callable bond pricing and call decision when there are transactions costs. When a capital structure is kept constant a firm that has outstanding callable bonds refinances them with similarly structured callable bonds. Since refinancing is costly, firms will delay the call decision. Given that the firm’s cash flows differ from investors’ cash flows, the valuation of the callable bond will be different for the firm and for the investors. We find that the investors’ valuation function exhibits three important empirical regularities for low interest rates: Inverse convexity, negative duration and market prices higher than call prices. In the region between the next optimal refinancing rate and the first time that the price of the bonds equals the call price, the market valuation of the bonds has a hump. To simplify the problem we have assumed that the firm will replace the outstanding bond with an identically structured bond. Because the firm will be replacing a seasoned bond with a new one, it will be pasting a function with itself at two different maturities. A head for the new issue and a tail for the seasoned bond. By following this procedure we collapse into a single step the problem of figuring out when to replace a callable bond with another callable bond that needs to be priced before pricing the former. This exchange of bond will occur at a lower rate than the normal call rate when cash in hand is used. Small transaction costs may justify waiting past the call price if the firm wants to keep a callable bond in its capital structure. We conclude that transaction costs alone may be enough to explain the overvaluation of callable bonds with respect to the call price. We use a general one-factor interest rate process in continuous time that nests most of the popular one-factor interest rate models used by researchers and practitioners.