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February 6, 2013 4:52 pm
Protection once thought to be standard for bond holders is beginning to evaporate as a furious rally on junk-rated debt shows little signs of abating.
Junk bonds can typically be redeemed early, a feature meant to allow companies to refinance outstanding debt and borrow more cheaply if their fortunes improve, or interest rates fall. But companies historically have had to wait for about half of the life of their bonds in order to “call” their securities.
However, the combination of rock-bottom interest rates and investors’ hunger for yields is enabling a growing number of corporate borrowers to limit the time period in which bonds carry the so-called “call protection”.
The average length of time between a new bond’s offering and the first date that the company can call or redeem the bond has dropped to three and a half years in 2012, the lowest level in more than decade, according to Dealogic data.
For investors, that is bad news because as more bonds get called earlier, they are faced with two unpalatable choices: they can either reinvest the proceeds in increasingly lower-yielding securities, or go deeper into junk territory to achieve the same returns.
“It’s getting harder to carry some of these high-yield bonds in portfolios,” said Jason Brady, a portfolio manager at Thornburg Investment Management. “It makes you wonder about what’s the upside of holding high-yield bonds that pay record low coupons, and that are being called sooner.”
Jeffery Elswick, a senior fund manager for Frost Investment Advisors, said: “New sales are coming with less protection. People who need to remain invested end up taking these bonds even if they come with shorter calls, or little covenants.”
In one example, US homebuilder Weekley Homes last month sold 10-year bonds that only included four years of call protection, instead of an average of five years. To compensate for the earlier than usual first call, it paid a small premium, appealing to investors’ craving for incremental yield.
“There is more lenience from investors and as long as investors feel like they are getting compensated for giving up that [call] option then issuers will keep pushing for it,” said Stephen Jaeger, head of Americas high yield capital markets at Bank of America Merrill Lynch.
Analysts also note that dwindling call protection is another indication of how near-zero interest rates are increasing broad risk-taking and helping bring back financing techniques that were popular in the credit boom of the past decade, such as dividends deals and payment-in-kind toggle notes.
Yet money continues to flow into high-yield bond funds from managers who need to put the cash to work instantly. Average yields on junk bonds touched an all-time low of 5.62 per cent on January 25, according to Barclays indices.
“The bargaining power is in the hands of the issuers right now,” said Marty Fridson, chief executive officer at FridsonVision, a financial research firm.
Additional reporting by Stephen Foley in New York
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