call vs refunding

[hellohi]

dear @David Harper CFA FRM @Nicole Manley @Dr. Jayanthi Sankaran

in corporate bonds reading, the writer mention that some callable bonds possess a feature that prohibits a bond call for certain number of years, and some callable bonds possess a feature that prohibits from being refunded for certain number of years, the question is what is the difference between bond call and bond refunding in this case?

best regards,
Nabil

 

[Dr. Jayanthi Sankaran]

Hi @hellohi,

From what I gather on reading 'Corporate Bonds' by Fabozzi, prima facie there seems to be an interesting difference. As far as callable bonds go, there is a period during which the company cannot call back the bond, especially during the initial years of the bond's life. This is to afford the callable bondholders with some measure of protection against a call.

Similar to the above, are a category of callable bonds with a 'refunding' provision, which cannot be refunded for a certain number of years. Prohibition of refunding prevents these 'non-refundable bonds' from being redeemed, especially if the funds for redemption are obtained by issuing new bonds with a lower coupon than the bonds being redeemed. However, if the funds for 'refunding' are obtained from other sources eg, asset sales, issuance of equity etc., they can be 'refunded'.

From the above, it is clear that Call prohibition for a certain number of years, offers more protection to the bondholder than a bond that has a 'refunding' provision that is otherwise callable.

Hope that helps!

 

[hellohi]

Hi @hellohi,

From what I gather on reading 'Corporate Bonds' by Fabozzi, prima facie there seems to be an interesting difference. As far as callable bonds go, there is a period during which the company cannot call back the bond, especially during the initial years of the bond's life. This is to afford the callable bondholders with some measure of protection against a call.

Similar to the above, are a category of callable bonds with a 'refunding' provision, which cannot be refunded for a certain number of years. Prohibition of refunding prevents these 'non-refundable bonds' from being redeeand med, especially if the funds for redemption are obtained by issuing new bonds with a lower coupon than the bonds being redeemed. However, if the funds for 'refunding' are obtained from other sources eg, asset sales, issuance of equity etc., they can be 'refunded'.

From the above, it is clear that Call prohibition for a certain number of years, offers more protection to the bondholder than a bond that has a 'refunding' provision that is otherwise callable.

Hope that helps!

thanks

but as I mentioned above , it seems to me that Fabozzi differentiate between bond calling and bond refunding, but really I didnot get the point, how they differ?

 

[David Harper CFA FRM]

@hellohi Thanks for a a great question (!) because, truth be told, I did not know the answer As usual, @Dr. Jayanthi Sankaran seems to be correct! Although it is not assigned in the FRM, fortunately Fabozzi explains the distinction between call and refunding provisions in Chapter 1 of The Handbook of Fixed Income Securities (i.e., the book from the FRM does assign Chapter 14). Because it is interesting, I have copied the entire section below (emphasis mine; please note the "exception" pertaining to municipal bonds which I *think* is how some people think of refunding really.

It seems the difference is that non-callable is absolute and signifies the bond cannot be called (i.e., during the deferment period or, never, if the bond lacks an the embedded call option) while a non-refundable bond can be called conditional on the criteria that new debt cannot be used to fund the retirement of the bond. Here is the full section.

Fabozzi Chapter 1 > Call and Refunding Provisions
If a bond’s indenture contains a call feature or call provision, the issuer retains the right to retire the debt, fully or partially, before the scheduled maturity date. The chief benefit of such a feature is that it permits the borrower, should market rates fall, to replace the bond issue with a lower-interest-cost issue. The call feature has added value for corporations and municipalities. It may in the future help them to escape the restrictions that frequently characterize their bonds (about the disposition of assets or collateral). The call feature provides an additional benefit to corporations, which might want to use unexpectedly high levels of cash to retire outstanding bonds or might wish to restructure their balance sheets.

The call provision is detrimental to investors, who run the risk of losing a high-coupon bond when rates begin to decline. When the borrower calls the issue, the investor must find other outlets, which presumably would have lower yields than the bond just withdrawn through the call privilege. Another problem for the investor is that the prospect of a call limits the appreciation in a bond’s price that could be expected when interest rates decline.

Because the call feature benefits the issuer and places the investor at a disadvantage, callable bonds carry higher yields than bonds that cannot be retired before maturity. This difference in yields is likely to grow when investors believe that market rates are about to fall and that the borrower may be tempted to replace a high-coupon debt with a new low-coupon bond. (Such a transaction is called refunding.) However, the higher yield alone is often not sufficient compensation to the investor for granting the call privilege to the issuer. Thus the price at which the bond may be called, termed the call price, is normally higher than the principal or face value of the issue. The difference between call price and principal is the call premium, whose value may be as much as one year’s interest in the first few years of a bond’s life and may decline systematically thereafter.

An important limitation on the borrower’s right to call is the period of call protection, or deferment period, which is a specified number of years in the early life of the bond during which the issuer may not call the debt. Such protection is another concession to the investor, and it comes in two forms. Some bonds are noncallable (often abbreviated NC) for any reason during the deferment period; other bonds are nonrefundable (NF) for that time. The distinction lies in the fact that nonrefundable debt may be called if the funds used to retire the bond issue are obtained from internally generated funds, such as the cash-flow from operations or the sale of property or equipment, or from nondebt funding such as the sale of common stock. Thus, although the terminology is unfortunately confusing, a nonrefundable issue may be refunded under the circumstances just described and, as a result, offers less call protection than a noncallable bond, which cannot be called for any reason except to satisfy sinking-fund requirements, explained later. Beginning in early 1986, a number of corporations issued long-term debt with extended call protection, not refunding protection. A number are noncallable for the issue’s life, such as Dow Chemical Company’s 85/8s due in 2006. The issuer is expressly prohibited from redeeming the issue prior to maturity. These noncallable-for-life issues are referred to as bullet bonds [david h note: "bullet bond" tends to confuse people. Technically, a bullet is non-callable bond, with or without coupons. You can have coupon-bearing or zero-coupon bullet (i.e., non-callable) bonds. But since many assume that bullet bond = zero-coupon bond, I think it's easier to avoid bullet except in the context of portfolio duration]. If a bond does not have any protection against an early call, then it is said to be currently callable.

Since the mid-1990s, an increasing number of public debt issues include a so-called make-whole call provision. Make-whole call provisions have appeared routinely in privately placed issues since the late 1980s. In contrast to the standard call feature that contains a call price fixed by a schedule, a make-whole call price varies inversely with the level of interest rates. A make-whole call price (i.e., redemption amount) is typically the sum of the present values of the remaining coupon payments and principal discounted at a yield on a Treasury security that matches the bond’s remaining maturity plus a spread. For example, on January 22, 2008, an industrial firm issued $300 million in bonds with a make-whole call provision that mature on January 15, 2038. These bonds are redeemable at any time in whole or in part at the issuer’s option. The redemption price is the greater of (1) 100% of the principal amount plus accrued interest or (2) the make-whole redemption amount plus accrued interest. In this case, the make-whole redemption amount is equal to the sum of the present values of the remaining coupon and principal payments discounted at the Adjusted Treasury Rate plus 15 basis points. [note 3]. The Adjusted Treasury Rate is the bond-equivalent yield on a U.S. Treasury security having a maturity comparable to the remaining maturity of the bonds to be redeemed. Each holder of the bonds will be notified at least 30 days but not more than 60 days prior to the redemption date. This issue is callable at any time, as are most issues with make-whole call provisions. Note that the make-whole call price increases as interest rates decrease, so if the issuer exercises the make-whole call provision when interest rates have decreased, the bondholder receives a higher call price. Make-whole call provisions thus provide investors with some protection against reinvestment rate risk.

A key question is, When will the firm find it profitable to refund an issue? It is important for investors to understand the process by which a firm decides whether to retire an old bond and issue a new one. A simple and brief example will illustrate that process and introduce the reader to the kinds of calculations a bondholder will make when trying to predict whether a bond will be refunded. Suppose that a firm’s outstanding debt consists of $300 million par value of a bond with a coupon of 10%, a maturity of 15 years, and a lapsed deferment period. The firm can now issue a bond with a similar maturity for an interest rate of 7.8%. Assume that the issuing expenses and legal fees amount to $2 million. The call price on the existing bond issue is $105 per $100 par value. The firm must pay, adjusted for taxes, the sum of call premium and expenses. To simplify the calculations, assume a 30% tax rate. This sum is then $11,190,000. [note 4]. Such a transaction would save the firm a yearly sum of $4,620,000 in interest (which equals the interest of $30 million on the existing bond less the $23.4 million on the new, adjusted for taxes) for the next 15 years. [note 5]. The rate of return on a payment of $11,900,000 now in exchange for a savings of $4,620,000 per year for 15 years is about 38%. This rate far exceeds the firm’s after-tax cost of debt (now at 7.8% times 0.7, or 5.46%) and makes the refunding a profitable economic transaction.

In municipal securities, refunding often refers to something different, although the concept is the same. Municipal bonds can be prerefunded prior to maturity (usually on a call date). Here, instead of issuing new bonds to retire the debt, the municipality will issue bonds and use the proceeds to purchase enough risk-free securities to fund all the cash-flows on the existing bond issue. It places these in an irrevocable trust. Thus the municipality still has two issues outstanding, but the old bonds receive a new label—they are “prerefunded.” If Treasury securities are used to prerefund the debt, the cash-flows on the bond are guaranteed by Treasury obligations in the trust. Thus they become AAA rated and trade at higher prices than previously. Municipalities often find this an effective means of lowering their cost of debt. "

 

[hellohi]

dear @David Harper CFA FRM @Nicole Manley @Dr. Jayanthi Sankaran

in corporate bonds reading, the writer mention that some callable bonds possess a feature that prohibits a bond call for certain number of years, and some callable bonds possess a feature that prohibits from being refunded for certain number of years, the question is what is the difference between bond call and bond refunding in this case?

best regards,
Nabil

dear @David Harper CFA FRM

thanks a lot for your interest to answer my iquiries, this is made me very happy and being more excited for studying because you rated my inquiriy here as this great rate, it is a great honor.

best regards,
Nabil

 

[Bucephalus]

Have a qn and I am not sure if it makes sense:
In a low interest rate environment, will a fixed price callable bond always trade above the call price? For example, based on the call schedule, the call price of the bond is $105 per $100 par value. In a low interest rate environment, while the firm wants to call back this series of bonds, in the market these bonds might be attractive owing to the higher interests they pay. Does this translate to call price < bond price. Is the following a fair interpretation?

When the bond is called:
Bond price > Call price > Par value

Alternatively, in a high interest rate environment, if a firm wants to retire a part of its debt, it can buy back the bonds form the open market if Bond price < Call price. Is this correct?

 

[Bucephalus]

Adding to the above post, I have a question on the make whole call provision:

Faboozi says the make whole call price moves inversely with treasury rates - which (as I interpret) is because make whole call price = PV of principal + PV of remaining coupon payment (discounted at treasury rates). Actually, the make whole call price is the greater of the formula above and the principal + coupon payments made thus far (But, let me ignore the second part for now). I understand the part in bold where call price is inversely proportional to treasury rates (assuming my interpretation is correct). Further, Faboozi says the issuer will not exercise the call to buy back the debt merely because borrowing rates have declined. I have a couple of qns on this:

1. When will an issuer exercise the make whole call option?
2. Can the item in bold (second) be extrapolated as "issuer can exercise the call to buy back the debt even when borrowing rates are increasing"? Why would an issuer do that? Will it be only to reduce debt and increase shareholder's equity?

Hope I am talking sense in the above.

 

[Bucephalus]

@David Harper CFA FRM Sorry, can you please help me out with the queries above? Looking forward to your guidance

 

[David Harper CFA FRM]

Hi @Bucephalus

On your first question, I don't think that's necessarily true. I think there are a few concepts here. One is the difference between theory and reality. Re: theory, a typical modelling assumption is likely to be that if an option is in-the-money, then the option holder will (or should) exercise the option; e.g., in the binomial model for a bond with an embedded option, the model is likely to employ a "simplified call rule" such for any given node, if the bond price exceeds call option strike price (i.e., the option is in the money) the holder (the issuer) will exercise the option. However, we know from reality and (actual prices) that embedded option holders do not necessarily exercise when it is financially optimal (e.g., the FRM's most notable example maybe is homeowner's not all necessarily re-financing--i.e., exercising their prepayment [call] options--for a variety of frictional reasons). So, my first point is that models might assume exercise when "in the money" but realistically we cannot expect that a company will call its bond just because their call option is in the money (ie, bond price exceeds strike price).

True, lower interest rates will increase the bond price, but it may not be true that (Bond price > Call price > Par value) because, please keep in mind, that bonds tend to pull to par and their current price relative to par is firstly a function of the relationship between yield and coupon. So for example, imagine that I issue you a 10-year bond when yields are 7.0%. If the coupon rate exceeds 7.0%, then the price > 100, and the strike schedule is likely to start above 100 (e.g., 120) but then taper down toward par, as under unchanged yields, the price will automatically pull down to par. But say it's a zero-coupon bond, then its price will be maybe $100*exp(-7%*10) = ~ $49.66. And if yields don't change, we expect that bond's price to pull up to par. So, I could imagine setting the strike schedule at 70 or 80 and "tapering up" to par. So my point there is that their is a price and pattern (pull to par) dynamic that is expected even before any interest rate changes are anticipated. Is that helpful?

Re: your second question, I need to bookmark it, sorry, I'm just candidly having trouble understanding it .... Thanks!