What matters to bondholders? Coupon, maturity, optionality, security, purpose, relative value – the other factors will all inform the ultimate coupon and maturity they are willing to take.
Embedded Options in High Yield Bonds – Callable Bonds
The majority of high yield bonds have call provisions in today’s market (they are callable bonds). This means that there is a call option for the issuer to redeem the bonds at a set price (typically 50% of the coupon declining ratably towards par as the bond nears maturity). Callable bonds need to offer higher coupons (in addition to the higher coupon for being less creditworthy), but are standard for high yield issuers because for them flexibility is key as opposed to the cheapest cost of funds.
As a review, a call option is beneficial for the bond issuer. They have the ability to call a bond back at a certain price after a certain time. Recall from bond math that if interest rates rise (all things equal – so assuming this is the only thing that changes), the price of a bond will fall because the present value of the cash flows has fallen. If interest rates fall, the price of the bond goes up.
The call price (strike price) allows the bond issuer to redeem the bonds, which it would probably only do if it were able to refinance at a lower rate (which means that either interest rates have fallen or their credit profile has improved drastically). This is disadvantageous to the bondholder (bond investor) because the price that they would have gotten if there was no call is higher.
Of course, there is no free lunch in the market and a call provision with less call protection (not allowed to call for a certain period) would result in the callable bonds clearing the market at a higher interest rate in order to attract investors in the first place.
Call Protection for High Yield Bonds
It is pretty standards for bond investors to have some call protection, but not absolute. Bonds without call options will still have make whole provisions that are typical in investment grade bonds, but these are so punitive that they are rarely ever used. With essentially full call protection, these bonds have known maturities like IG bonds and will thus demand a far lower coupon.
Usually, the bond will not be callable for ~50% of the maximum life of the bond (assuming it is not called). The syntax is as follows 5NC2 (5 year maturity, not callable for 2 years), 8NC3 (8 year maturity, not callable for 3 years) and you can have 2.5 or 3.5 – whatever is negotiated.
Let us look at a 5NC2 for example. For the period preceding 2 years, this is known as the hard call period. Bonds are not callable (although they can pay the punitive make whole which bondholders are ok with). After 2 years, this is the soft call period where they can pay according to a fixed price schedule that declines to par as the bond nears maturity.
So for a 12% coupon bond, this is usually half the coupon in the soft call period declining ratable towards par so the call schedule will be $106, $104 the next year 102 the next year and par 6 months before maturity. Of course, this, like anything else in the bond contract can be negotiated.
The Make-Whole Call
This is also a call option but usually just referred to as the Make-Whole (MW) and not a key consideration for high yield bond investors in terms of making the investment decision as long as it is there. We will elaborate on the mechanics in a later post but the idea is that bondholders must be “made-whole” for the refinancing risk if the bonds are called during the hard call period.
The make whole price is the greater of par or the present value of all future cash flows from the bond contract. You would think that this is the definition of the price of the bond, but the discount rate you use is not the yield to maturity but rather a benchmark risk free rate plus a small make whole spread, making the bond trade at a substantial premium.
Put Provisions in High Yield Bonds
High yield bonds will typically have a 101% change-of-control clause so if the company is acquired, bond investors will get back their principal at 101% of par.
Equity Clawback Provisions
Equity clawback means that the company can retire some of the debt issued in the HY offering. This allows an equity issuer to be pragmatic with their capital structure as they could have possibly raised equity but in a volatile market or one that does not recognize the story they had to go down the debt route.
Usually, the company can use equity issuance proceeds to “clawback” 35% of the bond principal at par plus coupon usually at a hefty premium of 10%. So while the option is on the bond issuer, the bondholder will be made whole in a way with the premium to par.
Yield to Worst
When finance students think about bonds they usually think about yield, which they associate with yield-to-maturity or YTM. That is the yield an investor would obtain by purchasing the bond and holding it to maturity. With the call provisions in high yield bonds, the most relevant yield that you will see quoted in publications by the leveraged finance divisions of investment banks is yield-to-worst or YTW.
High Yield Bond Structure
For higher rated high-yield debt, they are fairly stable and standard instruments with normal (at-market) covenant packages and rates. BB rated (creditworthy for junk bonds) will just have straight cash coupons – for a $1,000 face value bond with a 7% coupon, they will pay $35 semiannually until call or maturity with standard make-whole and call provisions.
The riskier the bonds – riskier being in the form of higher leverage, weaker interest coverage and liquidity, and subordination in the capital structure such as second-lien claims on assets (2L) – the more structured and bespoke the debt must be. So this could be in the form of some of the interest being payment-in-kind (PIK) – which means interest is paid in the form of more debt principal or an equity component, possibly equity warrants (similar to options on the equity).
Sometimes, the bonds are so risky that prospective investors may want to see an associate equity raise before they invest or for there to be a haircut on existing debt before they are willing to play.
The buy-side investors that play in each segment of the high yield market may also vary greatly. On the more creditworthy side, closer to BB+ and Ba1, there is not a lot that separates these companies from investment grade issuers in terms of leverage or coverage. They could be pegged just below IG because of smaller size and may grow into it or are already under “positive watch” by the rating agencies and will be upgraded if sterling financial performance continues.
Plenty of mutual funds will market themselves as “high yield” funds while only participating in the stronger side of the credit curve. Investors who want a little bit more yield but not the speculative nature of B and Caa rated bonds may be interested in this fund mandate.
Conversely, once you get to the highly levered or even distressed side around CCC+, a lot more hedge funds – credit focused and otherwise will come out to play.