From Bond Vigilantes:
2013 saw a record year for new issue volumes in the European high yield market. A total of $106bn equivalent was raised by non-investment grade companies according to data from Moodys. Whilst this is beneficial for the long term diversification and growth of the market, there have been some negative trends. Given the intense demand for new issues, companies and their advisors have been able to perpetuate the erosion various bondholder rights to their own advantage. What form has this erosion taken and why are they potentially so costly for bondholders? Here we highlight some of the specific changes that have crept into bond documentation over the past 2 years and some examples that demonstrate the potential economic impact for investors.
1) Shorter call periods – high yield bonds often contain embedded call options which enable the issuer to repay the bonds at a certain price at a certain point in the future. The benefit for the issuer is that if their business performs well and becomes less financially risky, they can call their bonds early and re-finance at a cheaper rate. The quid pro quo for bond holders is that the call price is typically several percentage points above par, hence they share in some of the upside. However, the length of time until the next call is important too. The longer the period, the higher the potential capital return for any bond holder as the risk premium (credit spread falls). The shorter the call period, the less likely the issuer will be locked into paying a high coupon. Take for example the situation below: reducing the call period has an associated cost to the investor of 2.6% of capital appreciation.
2) 10% call per year at 103 – Similar to the example above, the ability to call a bond prior to maturity has the impact of reducing potential upside to investors. One innovation that favours issuers has been the introduction of a call of 10% of the issue size every year within the so called “non call” period, usually at a preset price of 103% of par. So assuming a 3 year “non call” period, almost 1/3rd of an issuers bond can be retired at a relatively limited premium to par. Take for example the counterfactual scenario below. Here we see the inclusion of this extra call provision has reduced the potential return to bondholders by 3.3% over the holding period....MORE
