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Buy Side

Debt Delivers Yields With a Kick

AUG 30, 2011 7:19pm ET
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Every bond has its season. In the current environment of ultra-low rates and a steep municipal yield curve, the sun is shining on premium bonds.

Par bonds and discount bonds tend to be the retail muni buyer’s product of choice, but analysts say yield-hungry investors who don’t want to compromise on credit quality should examine the benefits of premium bonds and their protective role in a rising rate environment.

“When rates are stable and at a reasonable level, it’s all about par bonds,” said Chris Mier, head of analytical services at Loop Capital Markets. “But when rates are low, like they are now, and people are fearful of rates rising, premium bonds are a good strategy.”

Of particular interest in this environment is what the market dubs “kicker” or “cushion” bonds — previously issued, high-coupon securities with a long maturity, which are priced to a shorter-term call date.

Kicker bonds play a defensive role in a stable or rising interest rate environment. They typically offer a higher current yield than comparable short-term assets, and they offer the possibility of even higher yields if the bonds are not called.

Their attraction stems from how callable bonds get priced in the secondary market as the call date approaches.

For instance, a bond with a 25-year maturity and a 10-year call option will be priced more like a 10-year bond because in a low-yield environment, the market will value the security at the yield-to-next call, or its yield-to-worst.

That’s because when interest rates have declined since the bond was issued, the borrower is likely to call the bonds. But to compensate investors for the risk that principal might not be returned at the call date, the buyer gets a higher current yield than comparable, non-callable munis maturing near that call date.

A nimble investor can purchase kickers on the assumption that they get called and scoop up some extra yield.

If interest rates rise, the call becomes less likely. This creates a different opportunity, for when the call date passes, the market reprices the bond’s yield to the new date, and the yield kicks up, hence the term “kicker bonds.”

PLAIN VANILLA

Let’s say you’re in the market for an intermediate-term bond.

One muni you think of buying has a 3% coupon, is maturing in June 2024, and has a 10-year call in 2021. It’s an essential-service bond, rated double-A, so it trades roughly 35 basis points off the Municipal Market Data triple-A yield curve, which is 2.80%. Priced to worst call, its yield is 3.15%, and its dollar price would be $98.43.

Compare that with a 5.5% coupon bond maturing in 2024, but with an earlier call date, in 2017. Its market yield is 3.05%, and its dollar price would be just under $113.

Retail investors tend to shy away from the second bond because it’s trading at a premium. They don’t like the idea of paying more for a bond than it will pay back at maturity. So they assume the first bond, offered at a discount and with a higher yield, is the better buy.

“But the second bond is trading at 3.05% to the call in 2017, so if the call isn’t exercised, its yield kicks up,” said Peter Delahunt, national sales manager in the muni group at Raymond James.

Its yield jumps because the market now assumes it will be called at a later date. If it’s never called, its yield will eventually kick to its yield-to-maturity, which at the purchase price above is 4.19%.

So if interest rates are the same by the time 2017 rolls around, the buyer would be holding a seven-year bond with a yield in the range of 3.40%, whereas a comparable non-callable, seven-year bond would yield roughly half that.

In addition, the premium bond boasts protection against Accrued Market Discount tax. Discount bonds mature at par, and that capital appreciation is taxed as income rather than a capital gain. So premium bonds, which amortize towards par, have long been used by institutional investors to reduce exposure to AMD, as Citi reported in an Aug. 22 research note.

THE CUSHION EFFECT

Mier said kicker bonds are highly desirable these days because investors are assuming that interest rates eventually will have to go up from current record low levels.

Buyers oriented towards total return are therefore willing to pay an up-front price for bonds that offer better performance characteristics in a bear market.

“Buying 'kicker’ or 'cushion’ bonds is a good way to take advantage of the current interest rate environment and build in some protection for yourself,” Mier said.

Mier showed the value of a kicker bond by hypothetically swapping a par-value bond for a premium kicker bond based on current market rates last Wednesday.

The swap involved selling $1,000 of par-value local school district bonds yielding 3%, and swapping them for $850 worth of premium Denver bonds yielding 2.88%. The investor can only buy $850 worth because the kicker bonds, in this instance, were priced at $116.20, rather than $100 for the par bonds.

Both bonds mature in 2024, but the school bonds have a call date in 2020, while the Denver bonds have a call date in 2019.

If interest rates remain unchanged over the coming 12 months, a simple calculation suggests the total return would be 3% on the par-value school bonds and 2.90% on the premium Denver bonds. Not much of a difference.

But if interest rates jump 100 basis points over the coming 12 months, the same calculation shows the total return on the school bonds would be negative 6.09%, whereas the Denver bonds would tumble by only 2.45%. Total return is the yield of the bond plus or minus depreciation or appreciation in price.

“That’s the attraction,” Mier said. “From an accounting standpoint, you’re giving up 12 basis points, but from a total return standpoint, if rates rise like you expect them to, you’re saving yourself three and a half points. So that’s why this kind of trade is being done.”

If an investor were certain that rates would jump higher, money market funds would be a better bet so you could take advantage of the higher rates, he said.

But nobody has certainty, so kickers “are a great way to stay in the game if you’re a long-term investor.”

IF RATES FALL

The risk is that should interest rates fall, kickers lag.

In financial jargon, kicker bonds feature lower effective duration, meaning they are less sensitive to a shift in interest rates. So they play a defensive role in a rising rate environment by losing value less quickly than a non-callable bond. (The jargon here is higher convexity).

This benefit comes at a cost: the yield-to-maturity on high coupon bonds priced to short call dates is typically less than a non-callable bond.

Moreover, if interest rates fall, kickers gain in value less quickly — lower convexity.

Mier, however, pointed out that an opportunity can exist for kicker bonds even in a falling rate environment.

When interest rates drop but outstanding debt isn’t currently callable, issuers have an incentive to do an advanced refunding — that is, the issuer borrows new debt at the lower rates, and uses the proceeds to purchase Treasury bonds whose interest payments will pay off the old debt.

The bond is now considered a top-tier credit because it is backed by Treasury bonds in escrow and since it will be called with certainty at its pre-refund date.

Mier notes this is a trade that people often use when they sense a bear market in bonds.

RETAIL APPETITE

Because rates have fallen so much in recent months, virtually all outstanding munis are trading at a premium. Finding kickers can be as easy as picking out bonds with call dates.

“Almost any bond coming out in the secondary is a cushion bond because we’re at some of the lowest rates we’ve ever been at,” Delahunt said.

Even in the primary market, premium prices have become the norm thanks to the standard pricing structure preferred by buyers for new issues.

Peter Hayes, head of municipals at BlackRock, noted that retail investors generally prefer buying bonds at a dollar price in the range of $98 to $102, but with new pricings often structured with 5% coupons, buying at par isn’t feasible.

For instance, last week’s King County, Wash., deal underwritten by JPMorgan offered 5% coupons on serial bonds running from 2013 to 2031, even though actual yields ranged from 0.29% to 3.94%. The 10-year bond in the series sold at a dollar price of $121.

It has taken retail investors a while to understand why anyone would pay more for a bond than what will be delivered at maturity, but that perception is slowly changing because rates have been low for a few years now.

“You rarely see a coupon-structure adjust down to the same degree that the yields are,” Hayes said. “That’s not what investors want. Everyone always thinks interest rates are going to go up — that’s just how investors predominantly think. So as rates come down, you don’t see coupons come down so much.”

As the market becomes more comfortable paying premiums, kickers should become a more familiar product to average investors.

But kickers can be tricky, so retail investors should rely on professionals to do the technical work, said Michael Pietronico, chief executive at Miller Tabak Asset Management.

“There are chances to overpay for these bonds if you don’t do your homework, if you don’t know what the non-callable bond is worth,” he said.

One thing to keep in mind is the importance of having a significant cushion to play defense against rising rates, according to Delahunt.

“If you have a bony butt and you’re sitting on a three-point cushion, you’re still going to feel uncomfortable,” Delahunt said, alluding to a premium bond at $103.

“What you want is a nice and fat 10-point cushion to sit on — a big old fluffy ­pillow.”

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