In finance, call protection refers to a provision within the terms and conditions that govern some type of financial transaction. Most often, this type of provision ensures that the originator cannot instigate an early resolution to the transaction, at least until the transaction has been in effect for a minimum amount of time. A call protection is common with some bond issues as well as different types of mortgages and loans.
Essentially, call protection prevents the issuer from instigating an early call on the financial instrument. In the case of bonds, this means that the bond issue must be in effect for a minimum amount of time before the issuer can implement a call and issue an early payoff to the bondholder. For example, if the bond is set to mature in ten years, this protective provision may ensure the holder that the bond will remain in effect and accrue interest for at least five years before the issuer can choose to make a call.
Call protection is also found in many types of loans, including mortgages. In this application, the protection may restrict the movements of both the lender and the borrower. For the borrower, there may be penalties for paying off the loan early, a move that effectively makes sure the lender still generates a decent rate of return on the transaction. At the same time, the lender is restricted from issuing an early call on the loan, except under circumstances such as default by the borrower, thus preventing an early call from placing the borrower in an undesirable financial situation.
Investors sometimes choose to purchase securities known as callable bonds. Essentially, these bonds are usually structured to allow the bond issuer to call the bond should circumstances become favorable to do so. With callable bonds that carry a fixed rate of interest, the issuer may choose to call the bond early if interest rates drop, effectively helping to save the issuer money. In exchange for the increased risk of an early call, bonds of this type are usually provisioned with a higher return, which does help to offset the risk to the investor somewhat.
For the most part, the idea of call protection has the goal of ensuring that the original duration of the financial transaction does take place, except under unanticipated circumstances. For investors, this means that there is a better chance of earning the return anticipated from the purchase of the callable bonds or other types of callable securities. For lenders, there is protection from early payoff of loans that result in a significant loss of interest income.
