Tuesday 04 November 2014 by Legacy

FIIG-originated bonds and early call options – how to assess the value

Most FIIG-originated bonds give the issuer an option to redeem (or ’call‘) at specified dates prior to maturity, a possibility that investors should be aware of when assessing the relative value of the various bonds.

Under the terms and conditions of the bonds, the issuer pays a premium to par if it elects to call the bonds early, which it may do to avoid paying an ongoing high interest (coupon) rate that is materially higher than the rate at which it could refinance the debt.

This premium amount is typically set at $103 at the first call date, and as the bond gets closer to its maturity this premium falls. The first optional redemption date is usually set at 2-3 years prior to the maturity date on the bonds.

An issuer’s current borrowing costs – which determine whether it would want to call early - are impacted by a number of factors:

1. How interest rates have moved since the time of issue, which will be influenced by the general level of interest rates.

This is a particularly important consideration for fixed rate bonds. If the issuer raised a fixed rate bond in a high interest rate environment, and rates have fallen since that time, then it may make sense to call the existing bonds early and raise new debt at lower interest rates (assuming the company does not have an interest rate swap in place).

This may still be an important consideration where an issuer has issued floating rate bonds. The issuer may decide to take advantage of a low interest rate environment and replace its floating rate bonds with fixed rate debt.

2. How the credit spread on the bond has changed since the time of issue.

This will be influenced by a change in credit profile of the issuer and the general state of the credit markets. For example, a company may have experienced improved earnings growth since the bonds were issued, or it may have de risked in other ways (through completion of a project) such that its credit profile has improved. In these situations, the issuer is likely to be able to raise new bonds at a lower credit spread than previously.

In a similar way, bonds that were issued when market credit spreads were higher may be refinanced in a lower credit spread environment if this persists around the time of call.

3. The ability of the issuer to access multiple funding sources.

As a company’s earnings base and market capitalisation grows, it is likely that it will be able to raise debt in more ways, including offshore debt markets. As such, access to new markets may allow the issuer to reduce its borrowing costs. This factor is also linked to the general state of debt and credit markets. Periods of low appetite for debt are typically characterised by high credit margins.

There may also be other factors involved in the decision to call early, such as:

  • Size of the call premium
  • The company’s ongoing requirement for debt funding
  • The desire to diversify funding sources by product
  • Duration
  • Currency

But a large part of the decision to call early will come down to whether or not it is economic for the company to do so and the state of the debt markets at that time.

An issuer also needs to consider whether it would damage its reputation by calling the bonds early as an early call may disappoint bondholders who were expecting to hold the bonds until maturity. This would make it harder to issue bonds in the future.

For investors considering investing in FIIG-originated bonds, it is worthwhile considering the ‘yield to call’ measure, which measures the yield on a bond if it was redeemed at a call date. The table below outlines the indicative yield to call (at each of the optional call dates) and yield to maturity for all 12 FIIG-originated bonds.

In the table above, the yield to call is higher than the yield to maturity for the more recent FIIG issues.   Whereas the relationship is the opposite for the earlier FIIG-originated issues.

Not all issuers will choose to call their bonds early, and many issuers will prefer to have debt locked away until the maturity date rather than having to go through the refinancing process earlier than anticipated. Therefore, investors should consider both the yield to maturity as well as the yield to call in making an investment decision.

Payce is an example where it may make sense for bonds to be called prior to the maturity date. Following the successful completion of its East Village development and the provision of a guarantee from the entity that owns the commercial/retail assets, the risk to bondholders has reduced significantly. It is likely Payce could raise new debt at levels below 9.50%pa, which is a very high rate.

For an investor considering investment in the Payce 9.50% December 2018 bonds, the first optional call date is in December 2016, at a redemption amount of $102. If Payce were to call the bonds early, an investor would earn an indicative yield to call of 6.07%, which is less than the 7.11% yield they may have expected on the assumption that Payce would hold the bonds until maturity.

However, investors should remember that the shorter the term, the lower the risk. A yield to call of 6.07% is still a high return should the bonds be called in just over two years’ time in December 2016.

Next week we will assess the performance of the 12 FIIG-originated bonds by comparing:

  • the credit metrics of each from the time of issue to now,
  • the price (and yield) performance of each bond, and
  • relative value given the risk and return considerations

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.