Catastrophe Call

What Is a Catastrophe Call?

A catastrophe call is a call provision in municipal bonds that considers the early redemption of the instrument on the off chance that a catastrophic event happens and seriously damages the project financed by the issue. Potential catastrophes will be listed in the bond's indenture and are frequently callable at par.

It is a type of extraordinary redemption provision used to offset lost revenue from a municipal bond that was issued to fund the construction of a community facility that later experiences critical damage, restricting its ability to produce revenue to repay the bond.

These ought not be mistaken for a calamity call, which is a protective measure for investors in a collateralized mortgage obligation (CMO) that is set off assuming defaults or prepayments on the underlying mortgages take steps to interfere with the cash flow produced by the investment.

Understanding Catastrophe Calls

Catastrophe calls give municipalities insurance against natural disasters. For instance, suppose a seismic tremor obliterated a recently developed bridge. Since the construction cost was financed by a municipal bond issue (with a catastrophe call option) and the bridge's destruction doesn't permit it to create the revenue expected to repay the debt, the bonds might be called at par right away. Since bonds with catastrophe call provisions carry a higher risk load for the issuer, they likewise generally have a higher yield than general obligation (GO) bonds to account for the risk factor.

It isn't beneficial for all municipal bonds to issue a catastrophe call provision, however catastrophe call provisions are more normal in revenue bonds. Revenue bonds are a specific type of municipal bond that are issued to finance specific projects that will, thusly, produce their own revenue. The idea is that in giving these types of bonds, the project's revenue stream will pay back the bond. Moreover, revenue bondholders typically don't have a financial claim to the completed project assets.

For instance, an institution that issued a revenue bond for a toll road can't then repossess the toll road if it doesn't deliver the expected and settled upon revenue to pay the interest and principal payment.

Catastrophe Call Example

Think about the accompanying scenario: The City of Pleasantville wishes to build another toll road due to its position as a major pass-through for voyagers throughout the mid year months. In any case, the City of Pleasantville doesn't have the important funds expected to build the toll road.

To finance the road's construction, the municipality issues revenue bonds to its occupants for fund generation, with the plan that the collected tolls will then, at that point, pay the payments and interest on the bonds over a term of 30 years, as set in the bonds agreement. Since the City of Pleasantville likewise is situated close to a separation point, the revenue bonds contain a catastrophe call provision, which the investors are aware of.

Three years after the project is financed and the toll roads are built, a quake hits the City of Pleasantville and the toll roads are impacted by the natural disaster. The tremor qualifies under the catastrophe call provision, and that means that the City of Pleasantville is eligible to call its bonds. Calling the bonds permits the city to pay off the bonds promptly as opposed to waiting for the original life of the bond, thusly turning away any excess portion of the bond's interest earnings.

Features

• Catastrophe call provisions are more normal in revenue bonds than GO bonds.
• Catastrophe call provisions generally have a higher yield than general obligation bonds since the issuer has a higher risk load.
• A catastrophe call takes into consideration the early redemption of a debt instrument assuming that a catastrophic event happens that makes damage the project being financed.
• These are most frequently associated with municipal bonds.