Searching for extra yield in a low interest rate environment, buyers have been asking underwriters to structure callable premium bonds in new issues and picking through the secondary market looking for them. “Kicker” or “cushion” bonds provide a lot of benefits that the buy-and-hold market participant may not be aware of. As the search for yield is intense in today’s environment, a multi-pronged strategy has become prevalent with these fairly simple bond structures. “The value of these bonds come down to market conditions and what your investment objectives are,” said Paul Brennan, portfolio manager for Nuveen Investments. “But often you will get a kick that can result in a lot of extra income, and if you are ready to tolerate some added risk you will often get rewarded with the extra yield that you wouldn’t have otherwise received.” Premium bonds with a call option are priced to the call date. For instance, a bond with a 25-year maturity and a 10-year call option will be priced as if it is a 10-year bond because the market will value the security at the yield-to-worst, or lowest quoted yield. What an issuer in the primary — or a bondholder in the secondary — will also do is offer the bond with some extra yield in order to entice an investor to purchase the bond as compensation for the risk that the bond does not get called. If a buyer is investing with this strategy in mind, they can refer to the premium bonds as cushion bonds, as there is a cushion of yield. If the bond does not get called, the holder receives a kick in yield. This is because now the yield-to-worst has been extended and with it so has the yield. The basic principal is if the bond is called right away the holder has to amortize the premium he is paying over a shorter period, if it is to a longer maturity then this period is extended. On top of this, the investor is getting an above-market coupon making the kick all the better. If the buyer is betting on the bond not being called, they are referred to as kicker bonds, as there is a kick in yield as the bond is priced past the call date. An April 19 JPMorgan-negotiated sale of $450 million of consolidated bonds by the Port Authority of New York and New Jersey can serve as an example. An insured bond maturing in 2032 has a 5% coupon and yields 4.35%, making its price approximately $105.2. The bonds are priced to the 10-year call option, but if the buyer is looking at Market Municipal Data, a straightforward insured 10-year bond that day should have yielded 3.93%. Thus, if the bond were to get called in 10 years, the owner picks up an additional 42 basis points of yield. Looking at the other side, if the bond does not get called, a 25-year bond priced to its yield-to-maturity should have paid out 4.49%, according to MMD. If the bond is not called, it would kick out to a 4.65% if it were to amortize yield-to-worst. The owner stands to pick up 16 basis points till the next call period, and will continue to yield more as the bond remains outstanding. Upping the ante on these bonds is the circumstance where the issuer decides to do an advanced refunding on the bonds. In the advanced refunding, the holder of the debt gets immediate benefits as the bond is considered a triple-A credit because they are now backed by Treasury bonds in escrow.Here another strategy is apparent with the structure, as the bond is now much more valuable, and can be traded at a higher value. The chances of this happening depend on the issuer, but in many cases, if a bond is already trading at a premium, the issuer will want to take in the savings of the market. “What some people will do is buy the bond hoping that it will get pre-refunded because then they get a big jump in price,” said Paul Toft, a managing director at Victory Capital Management. “This is kind of a back of the envelope way that some guys have been trading them lately, but if you do a little research and think they have a good chance of getting refunded then it may be a good buy.” One other advantage that many buyers see in this structure is that they are relatively safe investments when looking at potential rate changes and the associated risk . As the Federal Open Market Committee has left the federal funds rate at 5.25% since August of last year, the market expectation is leaning against a rate easing in 2007 because of inflation concerns. A premium bond with a high coupon can be safer when it comes to interest rate risk. A buyer is paying more for a higher coupon with less duration, meaning that if rates rise, the bond will lose value slower because the buyer has paid up for a larger coupon. Increasing allocation to a more defensive structure such as the kicker bond makes sense for rate-wary investors. “Sometimes we call these bonds defensive bonds because they have high coupon priced to a short call date and naturally put the investor in a defensive position when it comes to potential rate increases,” Brennan said. On top of their demand in the primary, traders are finding them more and more in the secondary as well. “A bond winds up at a premium often times because interest rates are lower than when they were issued,” said Fred Yosca, managing director and head of trading at BNY Capital Markets. “The bond might have been issued at par or even at discount, but rates at that particular maturity have fallen and low and behold the bond is trading at a premium.” While there are a variety of strategies with these bonds, there is added risk to them. The short-term buyer of these bonds is hoping the bonds get called, as there is an inherent rise in yield to the bonds. But they do not always get called. This can be called extension risk, and it can be quite problematic for short-term buyers who buy a kicker bond betting on it being called. The opposite can be a problem as well, as when a bond is called when the buyer was hoping on it being extended out to its maturity. Another problem with these bonds is that under current tight spreads, the kick or cushion is diminished, and for some it is making the risk not worth the yield. In comparing the MMD yield-to-worst changes in just the last year, diminished yield is seen. Take the MMD yield-to-worst from a 5% coupon, 10-year bond to a 5% coupon 30-year bond on June 1, 2007, and the spread is 34 basis points. On June 1, 2006, this same spread 51 basis points, a difference of 17 basis points. “If I get a bond pre-refunded or if it doesn’t get called and goes on to its maturity, there is just not as much pop as there used to be because the yield curve is so flat,” Toft said. “Looking at the yield-to-call versus the yield-to-maturity, you see that there just isn’t as much of a disconnect on that if we were in a steep yield curve environment.” Dan Genter, president and chief executive officer of RNC Genter Capital Management, agrees, and said it is hard to find quality kickers anymore. “Given where rates are right now and how long we’ve been this low, most of these bonds have been called because issuers want to take advantage,” Genter said. “And for the ones that are left, there really isn’t much pick-up. Why am I going to take the risk of getting in trouble for picking up that small of spread?” In the meantime, the bonds continue to be issued in the primary, as underwriters know that the structure is marketable to a variety of buyers.
