As the popularity of the high-yield market has increased in recent years, there has been a shift of power away from fund managers towards the issuing corporates that has enabled them to weaken investors’ rights in bond documentation.
In particular, more recent corporate issues have changed their call-protection clauses, allowing the company to redeem their bonds after a shorter period of time than they did in the past, or introducing ‘special call’ features that allow redemption of 10% of outstanding bonds at 103% of par.
Typically, high-yield bonds would have a maturity of 8-10 years and would be call-protected for half of their maturity. Richard Inzunza, fixed-income portfolio manager at Northern Trust Asset Management says: “Recent issuance has had short call period – for example, an eight-year maturity with only three no-call years, or a five-year maturity with a two-year non-call period. Issuers have been able to shorten call periods because of investors’ concern over interest-rate risk.”
Mitch Reznick, co-head of credit at Hermes, says: “In combination with this demand for shorter-duration products, there has also been under-supply.”
Two key factors have driven the supply-side crunch. “Some investors have switched out of emerging market paper back into US and European high yield,” says Kevin Kearns, portfolio manager and senior derivatives strategist for Loomis, Sayles & Company. “And US issuance has fallen by a third.”
Many high-yield investors fail to realise the true value of call protection. Tim Dowling, lead portfolio manager of the global high yield strategy at ING Investment Management, says: “This is a market that tends to price changes in terms very badly. Call protection is very valuable feature for an investor, yet it tends to be only priced at 12-25 basis points.”
Dowling agrees: “The market is yield hungry and would rather have an extra 25 basis points on the coupon than ensure the bonds call features are truly robust and in the favour of the investor.”
This erosion in call protection is a negative development for the holder of the bonds as it erodes the bond’s ability to increase in value.
“The very nature of a bond investment means, unlike equities, there is limited potential for capital appreciation,” explains Steven Oh, head of global credit and fixed income at PineBridge Investments. “Shortening the call protection curtails that potential for an increase in value even further.”
Most high-yield investors expect to be compensated for the very real risk of credit default with the potential for some companies to improve their credit profile over time, causing the value of their bonds to increase. However, a shorter call protection period curtails this potential increase as it makes it more likely the bonds will be redeemed so that issuers with improved creditworthiness can re-finance on more favourable terms.
“If the bond can be called within a year, then the amount of capital appreciation will be less than if the bond had another five years before the company could redeem it,” says Reznick.
While none of this is welcome news for investors, it is a reflection of the current market environment: as market demand exceeds supply, issuers are more able to call the shots.
“Usually this shift in power is reflected either in the price of a security, or the coupon paid to the investor,” says Oh. “It’s been a relatively recent change that some of the private equity firms that control many of these firms prefer to reduce the covenant structures instead.”
From a private equity firm’s perspective, this erosion of the call protection makes perfect sense. A private equity firm’s priority is to sell the companies it bought in order to realise the return.
“However, if a private equity firms sells a company two years before the end of the call protection, that could be very expensive, as the charges for redeeming the bond early could amount to a material part of the value of the bond.”
Not only is the shift of power towards suppliers allowing them to erode call protection but the popularity of high-yield market is causing prices to trade very close to call prices, creating further problems for investors.
According to Kearns, a recent survey carried out by Barclays showed that around 30% of the market is trading at above its call price, while the remainder of the market is trading near its call price. Kearns says: “This means the market is expecting around 70% of bonds to be called.”
If, however, those bonds trading at their call price are not called within the next 1-2 years, as one might expect, investors will remain exposed to interest rate and default risk for the remaining life of the bond – perhaps 3-7 years, instead of the expected two.
To be compensated for these extra risks, the investor would expect the value of the bond to appreciate. But once the price is above its call price there is a much higher risk the bond will be called and the investor will lose out on the difference between the market and the call price, adds Kearns.
Investors face two equally unappealing possibilities once the market trades at the call price. If the market stays at the call price, investors are exposed to uncompensated risks if the bond is not called and if it rises above the call price, they will lose money once the bond is called, says Kearns.
“This erosion of call protection is entirely part of the high-yield cycle,” says James Gledhill, global head of high yield at AXA Investment Managers. “An investor must determine whether it is being paid enough for the risk they are taking and that includes trying to determine how much erosion of call protection will negatively impact the potential capital appreciation of a bond from positive credit events.”
But despite the erosion in the covenant structure of high-yield bonds and the problems caused by the majority of bonds trading at their call price, there is some light at the end of the tunnel. The current interest-rate environment means that this erosion of call protection may end up being less important than it seems today.
“Most investors think that the only way is up for interest rates,” says Gledhill. “In an environment of rising rates call protection becomes less relevant as companies are less likely to call because financing costs will be higher rather than lower.”
While that still leaves a risk of a call by an issuer that has experienced a dramatic improvement in its creditworthiness, it at least begins to tip the scales back in favour of the investor.