What is a Catastrophe Call?
Catastrophe calls are provisions in bonds that allow the issuer to call the bonds if the item built or produced by the bond is destroyed.
How Does a Catastrophe Call Work?
Let's assume ABC Town wants to build a new toll road, but it doesn't have the money to fund the construction. It could issue revenue bonds, and the tolls collected from the toll road would fund the interest and principal payments. If the revenue from the toll road is insufficient, ABC Town might not be able to make timely interest and principal payments.
Let’s say ABC Town issues those bonds, and now it has to make interest and principal payments for, say, the next 30 years.
Now let’s say that two years after the road is built, an earthquake occurs and the road is demolished. If the revenue bonds have a catastrophe call provision, ABC Town can call the bonds, meaning it can pay off the bonds immediately instead of having to make 28 more years of interest payments. This is good for ABC Town, which avoids the added expense of all those useless interest payments. But it is bad for the people who bought the ABC Town bonds -- they got their money back (the town paid off the debt), but they’re going to miss out on getting 28 years of interest payments.
Why Does a Catastrophe Call Matter?
Catastrophe call provisions are common in revenue bonds, which are municipal bonds that are issued to fund specific projects that generate their own revenue. Revenue-bond holders generally have no claim to the project’s assets (i.e., they cannot repossess the toll road if it does not generate the promised interest and principal payments). Revenue bonds may also have catastrophe call provisions. Thus, revenue bonds generally warrant a higher yield than general obligation bonds to compensate for these added risks.