The demise of callable bonds?

During the past fortnight, another two issuers redeemed their bonds and replaced them with new ones. The two bonds, namely the 7.15% Mediterranean Investments Holding plc 2015/17 and the 6.2% Tumas Investments plc 2017/20, both had early repayment options and therefore these are referred to as callable bonds. However, while Mediterranean Investments Holding plc redeemed its bonds towards the final redemption date rather than in 2015 or 2016 as a result of the uncertainty in Libya in recent years and the company’s weak financial performance, Tumas Investments plc availed itself of the earliest redemption date and issued new bonds at 3.75% to replace the 6.2% bonds that had been issued in 2010.

In recent years most companies redeemed their callable bonds at the earliest possible redemption dates mainly as a result of the sharp decline in interest rates and concurrently offered new bonds at lower rates of interest. In all cases, the new bonds being issued are plain vanilla ‘bullet bonds’ with only one redemption date.

So why are companies not issuing callable bonds anymore?

In an opinion paper published in February 2014, the European Securities and Markets Authority (ESMA) included callable bonds among those securities within the category of ‘complex financial instruments’. Shortly after this publication by ESMA, the Malta Financial Services Authority (MFSA) issued a circular to all investment services licence holders making reference to ESMA’s classification of complex financial instruments and the obligation on financial intermediaries to abide by certain practices when dealing in complex securities especially for retail investors. Apart from the need to conduct and document the appropriateness test assessment and the suitability test depending on the service being given (advisory/non-advisory), the MFSA issued another circular in November 2015 reinforcing the importance of the appropriateness and suitability assessments, particularly in the case of complex instruments and highlighting best practice in this respect such as the requirement to elicit clear answers from clients in respect of the investment’s features. In the November 2015 circular published at the time of the subordinated bond issue of Bank of Valletta plc, the MFSA also stated that a licence holder that carries out a suitability or appropriateness test must ensure that the investor understands the particular features of the instrument or product by providing “clear answers from specific questions presented to the client about the product features in order to confirm that the client is effectively aware of the features and risk of the product or instrument in question”.

As such, investors need to undergo a ‘question and answer’ session before being allowed to carry out any transactions in complex financial instruments.

Since callable bonds also feature as a complex instrument and due to the lengthy procedures in carrying out such an investment, most companies did not consider early repayment options and opted for bullet bonds instead. In fact, the last time that a callable bond was issued by a company other than a banking institution was Gasan Finance Company plc in October 2013. Also in 2013, Medserv plc had issued two callable bonds as part of a debt issuance programme which had then merged into one bond after the first interest payment date. In the banking sector, Mediterranean Bank plc had issued a callable bond in November 2014 but even excluding this early repayment option, this bond would still be classified as a complex financial instrument since it is a subordinated bond and thus additionally also falls within the BRRD regime.

Following the early redemption of several callable bonds in recent years and the announcement by Grand Harbour Marina plc earlier this week, there are only four non-financial callable bonds remaining. Simonds Farsons Cisk plc had issued €15 million in bonds in 2010 and these can now be redeemed on any date by giving 30 days’ notice to bondholders. Given the high interest rate on these bonds and the strong improvement in the Group’s financial performance in recent years, it is widely expected that these bonds will also be redeemed in the months ahead. Meanwhile, the other callable bonds still have some years to go before they can be redeemed. These are the €25 million 4.9% Gasan Finance Company plc 2019/21, the €7.5 million 6% Corinthia Finance plc 2019/22 and the €20 million 6% Medserv plc 2020/23.

Although the reason for the lack of issuance of callable bonds is now clear, it is still worth highlighting the advantages for companies of issuing callable bonds and also the advantages as well as disadvantages for both companies and investors of bullet bonds.

Companies mainly issue callable bonds to offer the flexibility for an early redemption as a result of various possible scenarios such as a change in the business dynamics of a company or to take advantage of a possible drop in interest rates at some point in the future. Property development companies would benefit from an early repayment option in the event of a very successful launch of a particular project since they could then repay bondholders earlier and not retain high levels of liquidity which are not easily invested at least at a similar rate to the coupon on their bond obligations. The main risk to investors when considering callable bonds is price risk when investing on the secondary market. Since a redemption of bonds normally takes place at the par value (100%), investors need to consider carefully the price being paid on the secondary market especially if this is above par.

While financial advisors always refer to the yield to maturity (i.e. the expected rate of return on a bond if it is held until maturity) when presenting options to investors to choose among a number of bonds, in the case of callable bonds, the yield to call is a very important determining factor that should be considered. Very often this may be overlooked.

The yield to call is the return of the bond assuming the issuer avails itself of the early repayment option at the first possible date. When interest rates decline, the value of callable bonds should not increase as much as normal bullet bonds do. This is because the likelihood of such bonds being redeemed early increases and the yield to call is the metric which should ultimately be considered.

Since most companies are now issuing bullet bonds at a time of a historically low interest rate environment, it is also topical to explain once again the risks behind such bonds. Many investors would have noticed that many local corporate bonds are of a 10-year term and the interest rates generally being offered are well below those seen in previous issues. Apart from the obvious risk of default, the interest rate risk is a very important consideration at this stage of the interest rate cycle. While fixing a rate of interest for 10 years has obvious benefits for several companies, if interest rates across the Eurozone continue to edge up from the very low levels which may be spearheaded by the decision of the European Central Bank to withdraw from the quantitative easing programme in 2018 or 2019, the prices of some of these bonds may indeed drop below their par value in the years ahead. While this may not pose a problem for those pensioners who are solely interested in receiving a regular stream of income over a defined period of time, it would be more problematic for those investors who may need to dispose of their bonds prior to the redemption date.

We are likely to evidence a number of new bonds coming to the market in the months and years ahead. While this is positive news for the thousands of investors who have ample levels of liquidity mainly due to the lack of alternatives from traditional bank deposits, the various risks associated with bond investing should never be overlooked. Financial advisers should assist investors to gauge the various levels of risk accordingly and whether their portfolio is structured in line with their financial objectives. Investors should also expect financial advisers to be adequately compensated for the time taken to explain the various levels of risk accordingly. Meanwhile, the extent of information being produced by issuers including the detailed Financial Analysis Summary is an important source of information for all investors.

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