In this article, I focus on bonds comes with callable features when issued and look into why the bonds are structured the way it is. The callable bonds tend to be from HY issuers. Bond options structured thru fixed income desk of investment bank would not be considered here as these are largely interest rate investment and hedging derivative products with government bond or highly liquid investment bonds as underlying instrument. The consideration can be different when compared with the cash HY bonds (e.g. the payoff of bond derivatives follow mechanical rule whereas the strategic financing decision at the company level would determine whether a HY bond be called – not just bond price in comparison with the strike).
The rationale for issuing a callable bond
When issuing a bond, the primary consideration of a corporate treasurer is to secure enough funding to support the financial strategy and the operation of the company. Once the funding requirement is satisfied, it is desirable to minimise the funding cost. While issuing bonds with longer maturity can lock in the funding for a longer period, the bond issuer could miss the opportunity to refinance at lower rate when the interest rate and credit spread later move to its favour. The callable feature of the bonds resolves this dilemma for the bond issuer.
The HY bond issuer tends to argue that their elevated funding cost is only temporary and thus justifies for an early refinancing (i.e. be able to call the bond early) if it manages to improve the credit metrics either through deleveraging or turnaround the business as planned. The untold reality is many HY bonds are issued to fund LBO and their financially sophisticated sponsors love to have the extra flexibility when executing their exit strategy. In the end, the callable bond benefits the bond issuers at the expense of the bondholder. It is an on-going tug-of-war between the issuers and the bondholder. If the bondholders are fine to accept more onerous terms (e.g. shorter non-call period) in a buoyant market, why don’t the bond issuers take advantage of that and refinance opportunistically when the market moves in a direction to their favour?
Why it is not that common to find callable IG bond?
While investment-grade issuers also have the incentive to issue callable bonds, they have a number of hidden costs need to consider:
- The business model of investment-grade companies is supposed to be more stable. The market generally does not anticipate the kind of big fluctuation in financing cost and need (when compared with HY issuers) to justify the more complex bond structure. Overemphasis on the financial engineering aspect could attract negative stigma.
- Mainstream investment-grade bond investors are not accustomed to a more complex product. Issuing a callable IG bond may reduce the potential investor base.
Why callable HY bond tend to have complex call schedule?
Figure 1 shows the call schedule of a typical HY bond. It is NUMFP 4.875% 2019, the same as the example we should in Part 1. It is a 5NC2 (5-year maturity non-call for the first 2 years).
The call schedule seems a bit arbitrary at first glance. It has multiple call dates with decreasing call price. It is common to set the call price at par plus a fraction of the annual coupon and step it down to par for the later days. In this case, the call price at the first call day is par + 75% of the annual coupon, the second one is par + 37.5% of annual coupon and the third one is a par call. But if we calculate the Adjusted Current Yield [= Annual Coupon / Market Price * 100 + (100 – Market Price) / Year to Maturity, with the Market Price set to the Call Price.] at each call date, the rationale behind the design would become clear. The adjusted current yields are 3.484%, 3.873% and 4.875% for the first, second and last call date. The bond is often issued at (or very close to par) with 4.875% yield. In other words, the bond issuer would allow the bondholder to take more upside (when the yield falls from 4.875% to 3.484%) if it is being called right after the 2-year non-call period. And the upside gradually reduces as time goes by. At the first par call date, the bond issuer can call as long as the yield is the same as when it was issued. In a sense, it gives a concession to the bondholder: call earlier only if the bondholder already has a better run. It also explains why the call price is not fixed. Say it is fixed at 103.656 (par + 75% of annual coupon) all the way thru, the Adjusted Current Yield at the later years would need to fall to a very low level before the bond issue can call and thus render the call feature useless.
Equity clawback – a hidden callable feature
One common exit strategy for many LBO is to go for an IPO. Since the company would have access to equity funding in a public exchange, the funding need will be reduced. It is common to see equity clawback clause in many of the HY coming out from LBO funding deal: once the company has started raising equity (thru public offering, but in some deals, it can be selling a portion of equity privately to any third party), the bond issuer can redeem a portion of the outstanding bond (usually around 35-45%) at a premium (usually par + annual coupon, the rationale being giving more upside to the bondholder as equity clawback clause can be triggered early and at unexpected time).
Why a bond issuer can’t rely solely on the latest bond price when determining whether to call?
Limited by the source of funding (either cash generated internally, equity raised thru selling shares or thru bond issuance in the credit market), a bond issuer may not have the resource to redeem the bond early even if it is beneficent on the paper. A bond issuer often needs to prioritise strategically. Here are some considerations:
- Maintaining seniority across capital structure: Typical HY issues have many classes of different debts (bank loan, secured bond, senior & subordinated unsecured bond, PIK etc). Creditors higher in the capital structure would demand the debtor to pay them in advance to the more junior debt holders. The requirement may be formally written as part of the covenant or is part of the tacit understanding. This means the junior debt cannot always redeem first at will.
- Maturity profile: the need to refinance bonds going to maturity in the near term.
- Optimise interest expense: after fulfilling the first two requirements, it is desired to refinance the most expensive debt first.
In addition, interest payment, redemption at a premium (in the case of call price above par), bond issuance cost etc subject to different accounting and tax treatments and thus further complicates the decision.
In relation to portfolio management, how bad is the negative convexity comes with the callable bonds?
All else being equal, no one likes an instrument with negative convexity of which the market value depreciation would be aggravated during a selloff. A bullet fixed rated bond is positive convex, so as a callable bond when its value is far below the call prices. There is a transition point in which the bond convexity changes from positive to negative when the bond price of a callable is above its call price.
But this negative convexity is relatively tame for two reasons. First, the region with negative bond convexity is limited. Once the bond price falls beyond the call price, the convexity will come back to positive. Also, the bond duration is low to start with before the selloff. These buffer the damage. Second, callable HY bond has higher carry and compensates the loss as the time goes by.
At the end, the main risks of holding HY bond are idiosyncratic default risk and systemic recession risk. We can take advantage of the callable feature of HY bond in particular part of the business cycle. The interest rate tends to rise once the recovery has clearly gained ground after a recession. Products take mostly interest rate risk (e.g. government and high-grade bond portfolio) would be worst affected. The higher carry of HY bond help to offset the loss (as at this point of the cycle recession risk is low). Callable HY bond priced below yield-to-call is even better due to their low duration in such region. It is no coincident that HY significantly outperformed government bond portfolio during when the Federal Reserve hiked interest rates in 1994.