A White Paper Follow Up
In March 2019 we published a white paper entitled, Callable Securities May Be the Biggest Threat to Your Portfolio. Recent market gyrations and Federal Reserve comments have presented a real-world opportunity to review a few of the themes contained in our white paper. In this follow up, we’ll build upon the ideas in the white paper and relate them to the rapidly changing perception of the economy and markets.
The issuer’s interest expense is the investor’s interest income.
In the white paper we made the point that callable securities favor the interests of the issuer over the investor. Investors in callable securities assume the interest rate risk of the issuer. It’s easy to understand the transfer of risk when we look at the investment from a slightly different perspective; that of a loan agreement.
The issuer is a borrower. The issuer wants to borrow at the lowest possible interest rate. The investor is a lender. The investor wants to earn the highest possible interest rate.
An issuer who borrows money in the bond market incurs an interest expense that must be paid to the investor over the life of the loan. The terms and conditions of the loan are subject to the provisions of their agreement.
The Interests of the Issuer/Borrower
To make a profit on borrowed funds the issuer/borrower must earn more than he pays to service the debt.
In this example, the risk to the issuer/borrower rests on the earnings side. If the rate of interest earned drops below the cost of the borrowed funds, the issuer may incur a loss. To protect against loss the issuer will often place a call option in the loan agreement.
A call option allows the issuer to terminate the agreement with the investor, on a predetermined schedule, according to the terms of the call option. The option to terminate the loan/investment allows the issuer to limit his exposure to falling interest income by refinancing his debt at lower cost. Should rates rise over the life of the loan/investment the issuer is pleased, as he has secured funds at a cost below their earnings potential, increasing his profit.
When we see the issuer as a borrower it’s easy to understand the attraction of a call option.
The Interests of the Investor/Lender
What incentivizes investors to accept an apparently one-sided agreement that puts the issuer in the driver seat and jeopardizes the investors future earnings?
Investors may favor callable securities in certain interest rate environments. These include environments of: rising rates, periods of low interest rate volatility, and flat and inverted yield curves.
Rising Interest Rates
Callable securities can act as a hedge against increasing interest rates. Upon issue, callable securities offer slightly higher rates than bullet securities. For portfolios managed to mirror a total rate of return index the additional income can help offset declines in market value. (Please recall that bond prices fall when interest rates rise.) The additional income is referred to as a ‘yield premium.”
Low Volatility
When monetary policy is on hold and the economy exhibits stability, interest rates may fluctuate in narrow bands. If rates remain within these parameters bonds may avoid a call, allowing the investor to earn the yield premium for extended periods.
Flat and Inverted Yield Curves
A flat yield curve displays similar yields across a variety of maturities from short to long term. An inverted curve reflects higher yields on shorter maturities than long.
These two yield curve examples make it difficult for the issuer to refinance profitably even as the security approaches maturity.
It must be noted that both flat and inverted curves carry warning signals of economic instability and are often interpreted as harbingers of recession. For an in-depth look at yield curves please refer to our commentary entitled, Every Yield Curve Tells A Story.
Yield Premium
The issuer of a callable security must pay investors a yield premium to compensate for the risk that the investment may be terminated prior to its scheduled maturity and the proceeds reinvested at a lower rate. For instance, an issuer may pay 2.25% for a non-callable security with a two-year maturity but 2.50% for a security of the same maturity with a 3-month call option. The additional 25 basis points is the yield premium.
Risk Reward Analysis
How does the investor know if 25 basis points is enough premium to compensate him for the call risk? This is where the analysis gets dicey because several variables come into play.
We’ve addressed the investor risk associated with declining interest rates. Since we can only guess at the future direction of interest rates this risk is unquantifiable. The investor is betting that any decline in interest rates will not be enough to trigger a call.
A second risk factor to consider is the rate of change or volatility in interest rates. Volatility in interest rates correlates with uncertainty about monetary policy and the economy. Greater uncertainty brings more volatility. Investors in callable securities are betting on low volatility. The most damaging scenario for the holder of a callable security is a sudden, sharp decline in interest rates, especially one associated with recession.
A third risk factor worthy of consideration is a steep yield curve. A steep yield curve exhibits market yields that decline rapidly, moving from longer to shorter maturities. As the callable security approaches maturity and is compared with increasingly lower market rates, the incentive for the issuer to call the security increases, as does investor reinvestment risk.
An additional risk factor to consider is the structure of the call option. As a rule, the more limited the call protection the greater the yield premium. Investors may accept limited call protection in exchange for a greater yield premium.
Call options take many forms. The five most common, European, Bermuda, American, Canary and Verde are detailed in the notes below. The difference in call features refers to the amount of call protection afforded the investor.
The key differences include the period from issuance to the first call date and the subsequent calls until maturity. Some initial call options may be exercised by the issuer after as little as a month from issuance while others may offer years of call protection. Some securities may be subject to call only once, while others may be callable daily, monthly, quarterly or annually following the initial call date.
From the investor’s perspective, limited call protection translates to greater call risk.
Current Economic Conditions and Monetary Policy
In our white paper we expressed concern that current economic conditions and the inverted yield were presenting worrisome signs that market yields might be headed for a slide. Except for the strong labor market, several economic indicators are flashing signs of caution. Suffice it to say fears of recession are creeping higher and market rates are moving sharply lower. This would be a worst-case scenario for callable bond investors. Our June 2019 Quarterly Commentary will address domestic and global economic conditions and US interest rates in depth.
Since November 2018, yields of US Treasury securities maturing from 3 to 10 years have dropped nearly 100 basis points (see graph below). The months of February, March and April have seen record numbers of securities called.
Lower for Longer
Federal Reserve Vice Chairman Richard Clarida has included important sentiments in speeches earlier this month. Clarida believes the global decline in policy interest rates used by central bankers to support their economies is likely to persist for years, making it harder to support those economies during recessions. Clarida said the downshift in policy rates “increases the likelihood” that they will return to zero in the event of recession. Clarida also expressed concern that zero policy rates may prove less effective and thus require lower rates for a longer period.
Conclusion
The conditions necessary to support the performance of callable securities have been steadily eroding. Market rates have dropped, volatility is high, the yield curve is signaling an economic slowdown and lower market and policy rates.
Investors should exercise caution when considering the purchase of callable securities.
Notes
Types of Call Features
European Call: Also known as “one time only”. If the security is not called on initial call date the security becomes a bullet.
Bermuda Call: Also known as “discrete call”. The security is callable only on specific dates, either monthly, quarterly, semi-annually or annually.
American Call: Also known as “continuously callable”. The security is callable anytime following the initial call date.
Canary Call: Specific to “step-up” coupon securities. The security may only be called prior to the first step-up in coupon and then becomes a bullet.
Verde Call: Specific to “step-up” coupon securities. The security may be called on future step-up dates
Disclaimer
The opinions presented within this white paper are the viewpoint of Institutional Capital Management, Inc. (ICM) at the time of distribution and are subject to change. The information contained is prepared from data sources generally believed to be reliable and available to the public, but no representation is made as to accuracy or completeness. This white paper is for general information purposes only and is not intended to provide specific advice or recommendation, nor is it an offer to purchase or sell any securities.
ICM is registered with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. ICM clients include city and local governments, hospitals, and similar public funds investors. www.thinkicm.com