Kicker Bond Prices Surge, Increasing Their Risk

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Kicker bonds may be getting too popular for their own good.

A combination of low supply and heavy demand has driven muni yields lower this year, adding to the appeal of the kicker bond structure, which rewards investors with higher yields if the issuer doesn't call the bonds on a specified date, analysts said. Demand for kicker bonds has also surged in recent weeks because investors are concerned the Federal Reserve may raise interest rates as soon as early 2015, and the structure offers a hedge.

But analysts warned not all kicker bonds are advantageous for investors. The heavy demand has made certain bonds overpriced, annihilating their value. Fred Bacani, Head of Fixed Income & Trading at Veritable LP in Newtown Square, Pa, said in an interview that the "sharp demand" for kicker bonds has made some maturities too expensive.

"If you have not bought the bond at cheap enough levels, you're stuck with little to no upside until the bond matures," Dan Heckman, senior fixed income strategist at U.S. Bank said in an interview. "The pricing of the bonds is very critical, and where the call dates take place is also a very critical component."

High Yields and Hedging Opportunity

Kicker bonds are premium bonds with a call provision, and are priced with the assumption they will be redeemed at an upcoming call day rather than their final maturity. If the issuer doesn't call the bonds at their call date, their yield spikes, or "kicks-up," rewarding investors for buying a bond made somewhat risky by an uncertain call.

The New York Metropolitan Transportation Authority's revenue 5s in 2029 were among the most actively traded kicker bonds in the two weeks through Sept. 10, according to data provided by Markit.

Their yield ranged from a low of 1.265% to a high of 1.283%, between 26 and 41 basis points below the levels where they were trading on Sept. 2, according to data provided by EMMA.

Also among the most actively traded kickers in the same period, the Atlanta Georgia Airport Passenger Facilities charge and subordinate lien revenue 5s in 2023, were trading at a yield of 1.73% on Sept. 11, about 22 basis points lower than on Sept. 3.

Kicker bonds tend to compensate investors for the risk with high coupons, a rarity these days as underwriters increasingly take advantage of the sparse issuance and price more bonds with 4% and even 3% coupons.

Anthony Valeri, CFA at LPL Financial, said in an interview that kicker bonds give investors a higher yield to maturity and a higher yield to call, so from that perspective they are cheaper than similar bonds with the same coupon.

"If you were to get the same coupon [on a non-kicker bond], you would have to pay more," he said. "You have to look at the higher yield to maturity kicker bond have. There is no way to escape paying a premium in the muni market, but you want to minimize the premium you pay and kicker bonds allow you to do that."

Another of the most actively traded kicker bonds in the two weeks through Sept. 10, the Cajon County California 5s in 2032, have a 2018 call and offer investors a 1.69% yield-to-worst. Standard & Poor's rated the Cajon County bond AA-minus.

Municipal Market Data's triple-A general obligation scale for bonds maturing in 2018 had a yield of 0.86% on Sept. 10.

San Juan Bautista California water and wastewater 6.25s in 2043s, which are callable in 2018, have a yield-to-worst of 2.495%. The bonds were rated A-minus by S&P.

The MTA 5s in 2029 mentioned above have a call date in 2017 and had a yield-to-worst of 1.265%. The bonds are rated A by Fitch Ratings and AA-minus by S&P. MMD's triple-A scale for bonds maturing in 2017 yield was 0.59%.

John Dillon, managing director at Morgan Stanley Wealth Management, said in an interview kicker bonds are a sensible purchase in an environment where rates are more likely to rise than fall because they hedge against reinvestment risk.

Heckman said the bonds even hedge against interest rate increases if you buy bonds with the assumption they will be called.

"If the environment is such that rates have the potential to rise, you can buy a kicker bonds for the cushion," he said. "If the bond gets called you get the proceeds back and can reallocate them at higher interest rate levels."

He said if the bonds get called it offers investors the opportunity to reposition themselves on the yield curve.

More Demand Means More Risk

As Bacani and Heckman mentioned above, demand for the structure is making kicker bonds more expensive and therefore, increasingly risky.

"The draw back with kickers is that they are a little less liquid, and part of that is due to redemption uncertainty," Valeri said. "If rates do rise that does not necessarily eliminate uncertainty of the bond getting redeemed before maturity or not. If you try to sell the bond then you might have some liquidity issues, if rates rise it might be a more difficult environment."

He said he views them as a buy-and-hold security.

Heckman said one of the scenarios investors should try to avoid is paying too much for a kicker bond, and then being forced to hold it to maturity.

Intermediate Maturities, Short Calls

The risk of buying overpriced bonds can be mitigated by doing more research on a kicker bond's structure and buying recommended maturity and call dates, analysts said. Overall they recommended intermediate maturities with short calls.

"I think the 10-15 year kicker structure is still attractive," Bacani said. "I also like intermediate-term bonds with short 1-3 year calls for investors who are remaining short in fear of a spike in rates, but have a yield bogey for intermediate-term bonds. This structure is a win-win, as investors can earn a higher rate versus non-callable bonds to the short call date and reap the benefits of a yield kick to maturity if the bonds are not called away."

Bacani said last week he bought Haverford Township School District 5.25s in 2025 callable in 2016 that offered a yield-to-call of 0.60%, double the yield of those offered by a 2016 non-callable bond, according to his analysis. He said the bonds offered a yield of 4.39% to the 2025 maturity, well above the 3.90% 20-year historical higher on the 10-year high grade municipals.

Heckman said that investors targeting bonds that will likely get called should look at kicker bonds that have a 5% coupon and a call in two or three years.

Investors who want to buy bonds that have a lower chance of being called should look at bonds with coupons at least 5% and up, analysts said.

"[I]f you are buying [kicker bonds] you want to buy further out on the curve, to the mid-point and further," Dillon said. "And the kick you want to keep it within seven to eight years if not shorter."

"You don't want to be too short, and the idea is you will get some potential kick on this bond if it is not called," he said. "The longer you hold it the more yield you are going to get, vs. yield to worse."

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