Early Retirement of Debt for Capital Structure
Debt Capital Markets may approach companies to discuss opportunistically retiring outstanding debt before the natural maturity date. As bonds are contractual obligations for a set period of time, the early paydown of debt must be negotiated unless there is a provision that allows for this under certain circumstances.
Often, corporates may want to issue debt early while rates are low while a maturity is further down the horizon. If there are a few potential catalysts for a rising rates, it could make sense to redeem debt and issue today. This is one of many levers that a corporate can pull, another one being the pre-hedging of debt.
This could also be because companies have cash-on-hand or other financing options and want to get rid of heavy interest payments – usually this would mean that the company is liquid and does not have immediate solvency fears. For instance, a company may see that interest rates have fallen over time where they can reissue at a far lower rate or extinguish the interest payments altogether.
This can get expensive as debt should be near or above face value, forcing them to pay full price. However, for companies that have issued high yield debt at high interest rates during periods when they were under far more distress and while interest rates were high, refinancing this debt can be a good way to save interest payments over time – an action that may be rewarded by shareholders.
When this is not purely a cost saving play but strategic – usually for companies that have high leverage depressing their stock price, this is more of a corporate finance advisory mandate and will be covered by non-execution investment bankers. Companies with high levels of leverage and debt that is trading below face value may look at ways to retire their debt opportunistically.
Early Debt Repayment Evaluation
Accretion to EPS from Early Debt Redemption
Accretion/dilution is very popular for investment bankers to look at and also a metric that easily resonates with shareholders. Investment bankers will look at the pro-forma impact of paying down debt today either with cash on hand or using proceeds from debt.
With cash, the number is simple – the interest payments will fall off and the loss on redemption of debt will be ignored as the investment banker shows “adjusted EPS” which does not include one-time charges.
With a refinancing, the investment banker will show the reduced interest payment (for instance, the bonds have been taken out by issuing secured term debt at a lower interest payment). Again, the EPS will be adjusted. However, in many cases this is still a good corporate action as the company is saving money over a longer period of time – depending on how the debt is redeemed, this can vary.
Present Value of Interest Savings from Bond Redemption
DCM will often run PV of interest payments based on what rates new debt can be issued at. For instance, the savings from retiring debt today and re-issuing assuming that interest rates rise. There will be a breakeven interest rate move calculated.
Again, these breakeven assumptions depend on how the debt is retired.
Debt Retirement Corporate Actions
Calling Callable Bonds
Callable bonds are the cheapest to retire as the issuer has the option to call the bonds at a certain price. When rates rise sufficiently, the NPV of calling back bonds is usually very positive (which is the reason why callable bonds are issued in the first place).
The catch is that callable bonds are more expensive to issue in the first place, as investors will demand higher yields for giving the company an option to retire debt when rates fall.
Paying Make Whole Premiums
Make whole premiums are a regular feature in most bond indentures, which allow for the issuer to call back the bonds while compensating bondholders at a favorable price.
Obviously, this is very expensive and rarely generates a reasonable NPV from the issuer’s perspective unless a substantial fall in interest rates is expected.
For heavily discounted bonds, this usually entails the bondholders being made whole at par (100 cents on the dollar). For bonds trading at a premium, this make whole may be even heftier as a function of the current benchmark interest rate. For long dated bonds nowhere close to maturity where the coupon is substantially higher than the current market yield, these bonds are prohibitively expensive to retire via make whole.
Bond Tender Offering
A company can tender an offer out to repurchase bonds to current holders of debt. What this means is that the issuer will offer to bondholders that they will agree to purchase up to a certain amount of debt at an outlined price at a specific time.
Unlike the make whole, this is not a call provision and instead represents a negotiation between the issuer and the holders of bonds – which means that the price can vary, although still at a premium to what the debt is trading at to entice bondholders to tender their bonds.
Tenders are often done when the bonds are trading at a discount, allowing bond issuers to retire their debt cheaply – even at a premium to today’s price.
Negotiated or Open Market Purchases of Bonds
Issuers can negotiate bond purchases directly with bondholders, or do so opaquely through brokers, to repurchase debt without paying a premium and while bonds are trading at a discount to their issue price. This is opportunistic but cannot usually be done on a massive scale.
Savvy issuers will look at a combination of all of these options.