Introduction
A callable bond is a bond where the issuer has the right, but not the obligation, to redeem a bond at certain points in its life before the final maturity date.
The two most common sorts of calls are calls for regulatory purposes (mostly banks) or to provide flexibility and ratings benefits to the issuer (mostly corporates). 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. For subordinated corporate bonds, Moody’s requires a final maturity date greater or equal to 30yrs and at least 10yrs between call date and maturity.
An issuer might choose to call an instrument at the first opportunity, an additional call date, or keep the bond outstanding until maturity. The treatment of call dates differs across markets. In the Australian market, there is generally a strong expectation that issuers will call securities at the first call date.
By contrast, in other markets, such as the European market, the exercise of a call option is typically viewed as a purely economic decision, with no presumption that the issuer will call unless it is clearly beneficial to do so.
Reasons for call dates
Call dates are a common feature of subordinated bonds and are primarily intended to provide flexibility to the issuer. These instruments rank below senior obligations and are structured to absorb losses in periods of financial stress.
Given their role in supporting capital stability, flexibility around the timing of redemption is more important for subordinated bonds than for senior debt, where certainty of repayment is typically prioritised. The uncertainty around the timing of principal repayment is reflected in the additional spread these bonds offer relative to their senior counterparts.
The call feature of these notes is usually a requirement from the regulator or ratings agencies. The purpose of this is to avoid the issuer having to refinance this debt in unfavourable markets in order to repay the bond holders.
If there was a serious adverse event at the time of the call date, then the issuer would be able to keep these bonds outstanding and simply wait until there were more favourable market conditions. This consideration also applies to idiosyncratic risk, as issuers may choose not to redeem the bonds until their financial position has stabilised.
This is rarely done in practice in the Australian market as there is an expectation from investors that the bonds would be called, and so failure to do so would result in the bond price likely selling off and investors being less likely to invest in the name in the future.
Whilst it is not the expectation, investors should always be aware that there is a risk that the bonds will not be called. Some factors that incentivise issuers to call their notes are ‘step-up’ features, where the coupon will increase after the first call date and equity credit which supports credit ratings from ratings agencies will be lost. Both of these factors raise the cost of debt for issuers, hence provide incentive to call on the specified date.
Ratings agencies treat subordinated corporate bonds as half debt and half equity for some of their credit metrics. This equity treatment will typically end at the first call date if the notes are not called. If this is the case, then the subordinated notes will become expensive debt since the spread on these notes is much wider than senior bonds (which also do not contribute equity characteristics to metrics, being classed as pure debt). This supports the economic benefits of calling the notes unless the company is in rather serious distress.
APRA’s focus on economic viability
In 2022 APRA published a letter to reinforce the need for a call in both AT1s and T2s to be economical. This came after a period of widening credit spreads where these instruments were routinely being called and replaced with more expensive debt. APRA said that they were seeing requests to make “uneconomic calls” and penned the letter to make a statement to the market.
Ultimately there was little substantive change following this announcement, aside from issuers needing to be more creative in building a case to justify the economic logic of the call to APRA.
While this development occurred several years ago, feedback from some issuers suggests that APRA continues to monitor this area closely. Although we do not anticipate any imminent changes, it remains important to acknowledge this risk.
It may not be an outcome that either investors or issuers would welcome, however the regulator’s role is to ensure these instruments function as intended. This includes preserving the issuer’s ability to not call the bonds at the first call date when necessary.
Final thoughts
Call dates are a common structural feature across many bonds in global markets, particularly for subordinated and hybrid instruments, and are typically included to provide issuers with flexibility around capital management, refinancing, and regulatory considerations.
A key takeaway is that just because a bond has a call date does not necessarily mean that this is the date on which funds will be repaid. Whilst this is the general expectation of the market, it is important for investors to acknowledge the genuine risk that this may not occur. This is becoming increasingly important with the growth of offshore companies issuing in the Australian market, particularly in the AT1 space. For the moment they are maintaining domestic market norms, but they may be less inclined to call their bonds if the economics don’t stack up.
For this reason, it is important for investors to not only look at the call date, but also the maturity date of these bonds. Redemption at the first call date is not a given and investors should be aware of how the duration and yield of the bond changes if it were to be outstanding until the final maturity date.
Mechanisms such as a step up after the first call date and the loss of equity credit for corporate notes are important to acknowledge. These features help to align the issuer with investors and provide them with a commercial incentive to call the bonds.