Fixed On Income: Understanding Bond Provisions
Since fiscal measures, started during the great recession, have pushed interest rates to almost non existent levels, and which sustained themselves at similar levels till the next crisis spawned in 2020, fixed income securities have seemed as if they are little more than things of the distant past, reserved only for the most conservative investors, of whom I hold the utmost sympathy.
Present level interest rates, however, will not sustain themselves forever. When the inevitable day comes when the Fed chairman elects to raise rates, a horde of investors, who have grown too accustomed to fiscal stimulus, may very well bring a turbulence to bond markets not seen since the early 2000s.
Should this day come, perhaps sooner rather than later, a grasp of fixed income securities, beyond a surface level understanding, may prove to be uniquely advantageous. While numerous characteristics can be applied to certain bond issues to make them unique in their own right, the most important aspect applied to bonds are the call provisions that an increasing number of corporations and municipalities instill in their issues.
To avoid this becoming a mundane description of call provisions in some professorial manner, the use of a real company may suffice in bringing a more effective explanation. Let us take U.S. Steel as an example, as it represents both one of the oldest corporations in the United States as well as a company requiring heavy capital expenditure, thereby increasing their possible need for a bond issuance.
If U.S. Steel were to issue bonds in a simpler time and in a simpler world it would consist merely of a principal amount of say $100 million for our case, an interest rate to be paid out semi-annually; 4% for our example, as well as a maturity date at which the principle of the bond would be paid off, let us say December 31, 2030. For 10 years, U.S. Steel would pay out $4 million per year to bond holders and on the last day of 2030 the $100 million principle would be redeemed and bond holders would receive their principle.
As this simplistic world exists only in fairy tales and economics textbooks, U.S. Steel will undoubtedly implement a number of provisions into their indenture, one of which will most certainly be a call provision. The volatile nature of interest rates brings a desire to corporations to be able to call their issue should interest rates move in favorable direction.
Most call provisions for bonds can be classified as having a deferred call provision, meaning that the issuer is not able to call their bond until a certain number of years have passed. If U.S. Steel had a deferred call provision for their $100 million bond issue stating that the issue could not be called for 4 years, the investors in their issue would be guaranteed that their interest payments would continue for a minimum of 4 years, assuming no default.
If, after 4 years, going interest rates fall to 2.5% it may only make sense for U.S. Steel to call their 2030 4s and borrow a similar amount at the going 2.5% rate. Investors in callable bonds then are incurring a risk that they will not receive interest payments for the entire time up until maturity.
To accommodate for this risk, call provisions usually state that a premium must be paid above par if an issuer decides to call the bonds before maturity. In addition, the bond indenture will state the date at which the bonds can be called, commonly known as the first call date.
For our example, let's say U.S. Steel issues their $100 million bond with a 4% coupon, a maturity date of Dec 31, 2030, a first call date of Jan 1, 2025, and a call price of 108. The bond will therefore pay out $4 million every year until the end of 2030, at which point the $100 million principle will be paid out to the bond holders. If the company wishes, they can call (pay off) the bond starting on Jan 1, 2025.
However, if U.S. Steel decides to call their bond issue, they must pay an 8% premium above par to compensate the bond holders for their interest payments being cut short. If coupon payments had continued until maturity date U.S. Steel would have paid out a total of $140 million over the ten year life of their bond [$100 million + (($100 million * 4%) * 10) = $140 million]. If they decide to call their bond on Jan 1, 2025 at 108 they will have paid out a total of $124 million. Assuming bond holders could not reinvest their money at similar rates, they are millions worse off than if the bond issue was never called.
By this point it will be obvious to anyone with a basic understanding of the time value of money that an additional level of complexity is needed in regards to a bond’s call price. If a bond is able to be called at 108 on Jan 1, 2025, it cannot make sense for that same bond to be called at 108 on Jan 1, 2029, given that at that point investors in the bond will only be foregoing 1 year’s interest payment. Thus reveals the importance of a call schedule.
Jan 1, 2025
Jan 1, 2026
Jan 1, 2027
Jan 1, 2028
Jan 1, 2029
As time goes on and the maturity date of the bond gets closer, the number of potential interest payments that a bond holder would forego if the bond was called decreases. To adjust for this peculiarity, bond issuers will frequently use a call schedule that lays out the different prices a bond can be called at depending on the date on which they are called. Using the example above we can see that the closer the bond gets to maturity date the less the issuer has to pay to call the bond. If U.S. Steel calls their bond on Jan 1, 2025 they must pay 107.96% to call the bond. If they wait until 2028 to call their bond they will only have to pay 102.50%, a difference of $5.4 million for their $100 million issue.
Whether a company decides to call their bond depends on multiple different factors but none more impactful than going interest rates in the U.S. If in 2027 going interest rates rise to 5% then it may not make much sense for U.S. Steel to call their bond. If, however, interest rates sporadically drop to 1.5% by 2028 then U.S. Steel can call their bond and borrow money at the going rates of 1.5%. While call schedules have grown in prominence mainly in America and are seen much less in foreign markets, they are still a vital factor in understanding bond issues.
Of course, titans of financial products could not merely stop there; alas such provisions become too widely understood to denounce their supposed authority. While bonds are technically fixed income investments, this could not stop London and Manhattan from bringing a floating rate aspect to this asset class.
To accomplish this, Make Whole Premium Call Prices have allowed redemption prices for bonds to diverge from their fixed income antecedence by tying the call price to a stated benchmark rate.
For example, a bond indenture may state that an issuer can call the bond at 100% of principle plus the sum of the present value of the remaining scheduled principal and interest payments, discounted back to the date of redemption, at the adjusted treasury rate, plus 25 basis points.
This provision means that the redemption price that an issuer can call the bond at fluctuates based on the U.S. Government Treasury rate. If government rates rise, then the discount rate being used in the Make Whole Premium formula increases, which in turn decreases the price at which an issuer can call their bond.
Conversely, if interest rates fall, then the redemption price to call the bond will increase accordingly. The decision between calling the bond at a higher price versus waiting till the maturity date to call the bond is up to the discretion of the management and how wisely they think they can allocate funds within their company.
Make Whole Premium call prices are a comparatively new concept within the fixed income markets but have gained more attention in recent years, particularly after the Libor scandal of 2012, as thousands of Make Whole Premium formulas are having to be rethought.
Far more complex provisions can be found within the 200+ page bond prospectuses released by institutions on a frequent basis, but such provisions are beyond the scope of this writing. It may seem laughable to spend considerable amounts of time thinking about bond investments given today’s peculiar interest rate environment; but more laughable are the individuals and institutions who believe this environment will persist indefinitely.
When a significant rise in interest rates inevitably comes, it will undoubtedly represent the shot heard around the financial world, which more likely than not will be followed by extreme fear and panic. The information here then should serve well those who may find themselves prepared when the shot goes off.