Note: This article addresses callable bonds and discusses Tier 2 and Additional Tier 1 notes. If you wish to understand the basics, please read the second article in this week’s Wire (click here).
Introduction
A callable bond is a bond where the issuer has the right, but not the obligation, to buy back a bond at a certain point/s in its life at a specified price/s before the final maturity date.
Not all calls are the same. Some are only shortly before the final maturity date, while others may be years before. Some are at par, and some are at values higher than par. Calls are also designed for different reasons. The most common two sorts of calls are calls for regulatory purposes (mostly banks) or to provide flexibility and liquidity to the issuer (mostly corporates).
Additionally, an issuer might, or might not, choose to call an instrument at the first opportunity. The decision is not always binary, nor is it always at the sole discretion of the issuer themselves.
We attempt to address the nuances of callable bonds by analysing the track record of Australian issuers.
The statistics themselves
The table below shows the statistics of all bonds issued by Australian-based companies deemed “callable” since the mid-1990s (subject to data constraints). We have excluded bonds that remain outstanding.
What stands out is the Subordinated and Junior Subordinated Call History section. Of the 185 that have been issued, 33 were not called on the first call date. Of these 33 bonds not called, 14 were issued by financial companies and 19 issued by corporates.
Regulatory view of AT1 and Tier 2 notes
From an issuing bank’s perspective, the decision to call a note comes down to two factors. The first, and less important, is the cost of refinancing. Banks are required to hold certain types of capital at certain ratios. When one type of bond matures (or is called), it is almost always replaced with a similar sort of bond, but that replacement is done at a new margin based on current market pricing. Issuers, in effect, choose between keeping the existing note outstanding (including step-ups, if applicable) and refinancing at existing market rates. Pure economic theory would tell you that the bank will simply choose the lower of the two prices.
Having said that, the reputational risk of a financial institution not calling the notes more than offsets the refinancing factor. Banks in Australia have established a track record of calling notes at the earliest opportunity which, all else being equal, allows them open and easy access to markets for funding. A bank choosing not to call could do a lot of damage to long-term funding costs across multiple transactions for the gain of saving a small amount on one transaction.
These factors however are by no means the regulator’s core concern. From APRA’s perspective, taking past performance as a given and believing it will continue in future would ignore the fundamental point of these instruments: to support a bank / insurer’s capital structure in the event of stress. It is critical to have the comfort that common equity and AT1 / Tier 2 instruments will be there when needed. As a result, APRA treats these instruments as regulatory capital on the basis of permanence.
Track record of the financial sector
Of the 14 subordinated and junior subordinated instruments that were not called on the first call date, we note the following:
- One had its first call date on the same day as the issue date, making it virtually impossible that the issuer would exercise the call option.
- One had its optional conversion date / redemption date extended to maintain sounds levels of total and Tier 2 capital. This Tier 2 note, issued by Bank of Queensland, had a call date in July 2011 at a time of high market volatility (Eurozone Crisis).
- One was not called because the notes were exchanged into new notes of the same issuer. Helia Insurance (at the time Genworth) had a regulatory AUD200m Tier 2 note with a call date in July 2020. On the call date, AUD147m was exchanged into a new Tier 2 note, with the remainder redeemed on the next call date in September 2020.
- Nine had call dates within the period 2002-05. We note that this was around the time that APRA announced its intention to implement the Basel II accords. We suspect that the issuers would have waited for more clarity from a regulatory point of view, at the expense of their reputations, for a brief period.
- Two had insufficient data to determine the reasons for the non-call.
These bonds all had a logical reason not to be called. This historical performance should act as comfort for investors nervous about the prospect of Tier 2 or AT1 notes not being called. This dataset also includes smaller deals – the larger, standardised 10NC5 and 15NC10 transactions are very frequently called.
Reasons for low call conversion in the corporate sector
On the other hand, corporate entities rarely redeem their callable notes at the first opportunity, with only 34 out of 160 transactions in the “other” category having done so. But the design and purpose of these corporate callable bonds is very different to the design and purpose of financial callable bonds. Financial callable bonds are callable for regulatory and stability reasons. Corporate callable bonds are more varied, but the main reason for corporate calls is to grant flexibility to the issuer around timing.
The first thing we’d note is that the vast majority of corporate bonds (89.6%) in our assessment are senior notes, which are the highest in the capital structure. These notes do not have regulatory capital requirements and issuers of these bonds face minimal (if any) reputational risks for not calling their notes. Most senior notes are priced to the final maturity date and in many cases, if not most cases, do not have a call date at all. However, those bonds that do have a call date would likely be in one of the two below categories:
- Senior notes may be issued with a make-whole provision, whereby the issuer, at its own discretion, may call the notes at an earlier date. In our experience, most make-whole provision dates typically occur only a few months before the final legal maturity date. For most issuers it is more logical and simpler to wait for the maturity date to arrive.
- Some notes will be issued with numerous call dates well in advance of the final legal maturity date (eg. three years prior to maturity, then two years, then one year.) However, these call dates are usually stipulated with a redemption price higher than par (say, at 102), which then incrementally steps down at each future call date. In the normal course of business, redeeming the notes at these prices would be an expensive option for an issuer.
In general, corporate bonds are normally not called due to the timing and price to do so. The call dates of corporate bonds are designed to give corporate issuers a little bit of flexibility with the refinancing task.
Final thoughts
The main takeaway, in our view, is that just because a bond has a call date does not necessarily mean that this is the date which funds will be repaid. There are lots of moving parts including, but not limited to, the regulatory perspective, the timing before the final maturity date, and broader financial conditions / events. Nevertheless, it pays to look at the past as it helps to set expectations (but remember, a call of a bond simply because it has happened previously does not guarantee that it will occur in the future). We found that corporate issuers mostly do not call their notes on the first call date, while banks and financial institutions do. This should provide a guide for noteholders going forward and a reasonable amount of comfort. We must reiterate, though, that the final decision around a call lies with the issuer (requires regulatory approval for financial institutions). While we can provide guidance about what is likely, there will always be a residual measure of uncertainty.