This week we continue our exploration of some important concepts of bond mechanics. Let’s don protective eyewear, roll up our sleeves and prepare to get our hands dirty as we probe the inner workings of call protection.
Fixed rate bonds usually benefit from a “call protection” feature that allows bondholders to lock in their yield for a period of time following the issue date. Call protection usually has two component parts: (1) a “non-call” period during which the bonds are not optionally redeemable by the issuer, except pursuant to a “make-whole call” feature, which we describe below (and, sometimes, other provisions that permit the issuer to redeem a portion of the bonds, such as an “Equity Claw”1), and (2) a period following the non-call period during which the issuer is required to pay a specified premium for electing to redeem the bonds prior to their maturity (typically, half of the stated interest rate on the bond, declining ratably to zero on the date that is two years (or, sometimes, one year) prior to the stated maturity date).
The non-call period for a high yield bond is typically one-half of its term. For example, the non-call period for an eight-year high yield bond is typically four years. The term sheet shorthand for such a bond is “8NC4.” A 10-year high yield bond typically has a non-call period of five years (shorthand: “10NC5”). However, there are exceptions to these general rules. Some high yield bonds are issued with even shorter non-call periods, and some investment grade bonds are issued with a non-call period that extends for the entire life of the bonds (such bonds are referred to as “non-call life”). Some non-call life bonds include a brief period prior to maturity (90-180 days, depending on the tenor of the bond) during which the bonds are redeemable at par, in order to afford the issuer a window to refinance the bonds without having to pay a prepayment premium.
The Make-Whole Call
In most cases, during the non-call period, bonds are nevertheless optionally redeemable at the option of the issuer pursuant to a feature known as the “make-whole call.” The make-whole call allows the issuer to redeem bonds during the non-call period at a redemption price equal to the sum of (a) the principal amount of the bonds redeemed plus (b) accrued and unpaid interest to the redemption date plus (c) a “make-whole” premium based on the present value of (i) the redemption premium that would be required to be paid if the bonds were to be redeemed on the first day after the end of the non-call period and (ii) the interest stream that would have accrued between the actual redemption date and the hypothetical future redemption date at the end of the non-call period if the bonds had been permitted to remain outstanding until the end of the non-call period. In order to calculate the make-whole redemption price on any date, you need to know how to calculate both the amount of accrued interest to the redemption date and the make-whole premium.
The Make-Whole Premium
The make-whole premium is formulated to give the bondholders the benefit of their bargain, i.e., to compensate them for losing the benefit of their call protection in the event the bonds are redeemed prior to the end of the non-call period. The make-whole premium is similar to a liquidated damages provision – it is a pre-agreed formula designed to estimate the present value of the remaining non-call period. The make-whole premium is equal to the excess of:
the present values of each remaining interest payment on the bonds for the period from the redemption date through the end of the non-call period, plus the present value of the redemption payment that would be due if the issuer redeemed the bonds on the first day after the end of the non-call period,
the principal amount of the bonds.
That excess is known as the “make-whole premium.” A make-whole premium can be substantial. A premium in excess of 15-20% of the principal amount of the bonds to be redeemed is not unheard of if the redemption occurs during the early part of the non-call period.
The present value of each remaining payment is calculated using a discount rate equal to the “comparable treasury rate” plus a spread (50 basis points in high yield bonds, and 25 to 50 basis points in investment grade bonds). The comparable treasury rate is the yield on the U.S. Treasury note having a remaining life to maturity that most nearly approximates the remaining term of the bonds (assuming an early redemption at the end of the non-call period).
1 An “Equity Claw” is an exception to the general “non-call” rule that permits the redemption of up to 35% (occasionally 40%) of the high yield bonds at any time during the first three years of the bond’s existence at a price equal to par, plus accrued and unpaid interest, plus a premium equal to the stated interest rate on the bond, with the net proceeds received by the issuer from the issuance of its common equity. Typically, the indenture will require that a portion (60%-65%) of the originally issued amount of the bonds remain outstanding immediately after such redemption, and in many instances the equity will be required to be issued in certain types of offerings (e.g., registered offerings under Form S-1 or S-3). Additionally, some first-lien secured high yield bonds permit the issuer to redeem up to 10% of the originally issued amount of the bonds during any twelve-month period prior to the third anniversary after the issue date at a redemption price equal to 103% of the principal amount thereof, plus accrued and unpaid interest.