Kicker bonds offer unique benefits depending on whether you are a short-term or a long-term buyer. But each strategy carries its own risks.
A real example using market prices from last week can help show these opportunity and costs.
New York City issued 5.25% coupon bonds in October 2003. The bonds mature in 2021 but are priced to the 10-year call date. At a dollar price of $110.1, their yield to maturity is 4.027%, but the market assumes they will be redeemed in October 2013, so they trade at their yield-to-next call, or yield-to-worst, which is 0.479%.
A short-term buyer expecting the call to be exercised can purchase the bond as a way of getting some extra yield. The attraction here is grabbing yield without sacrificing credit quality or explicitly extending out the curve.
As low as the 0.479% yield is, the two-year yield on Municipal Market Data’s benchmark curve has plummeted more than 40 basis points in recent months to just 0.30%. MMD’s two-year curve, which aligns with New York’s double-A ratings, is just 0.39%.
Buyers sometimes call these “cushion bonds” because of the extra cushion of yield.
A longer-term investor who believes the interest rate environment is stable or that interest rates could rise might also purchase this bond. The bet there is that the call would not be exercised.
If these New York bonds aren’t called in October 2013, the next call is October 2014, so the yield-to-worst kicks to 1.91% from 0.479%. Once that date passes, it kicks to 2.65%. A year later it increases to 3.11%, then to 3.41%, and so forth until its yield to maturity in 2021 is realized at 4.027%.
The current steep tax-exempt yield curve makes muni kickers more appealing.
The two-year to 10-year spread among triple-A munis has averaged 232 basis points so far this year, versus just 24 basis points during the same period in 2007, according to MMD. The steeper the slope, the greater the kick.
Michael Pietronico, chief executive at Miller Tabak Asset Management, said the steep curve coupled with tight credit spreads make kicker bonds “trade at a much higher price as you move through time because of the need for income on the short end of the curve.”
The concern in buying kickers for the short term is “extension risk.” In the New York example, if rates back up and the call option isn’t favorable to the issuer, these bonds could extend out another eight years to 2021.
That’s problematic if you’re depending on the principal redemption, as you would be stuck with these bonds when better opportunities might exist. In that case, you might have been better off sticking with short maturities and rolling them into higher-yielding bonds once rates rose.
The upshot is that kickers play a protective role in a rising rate environment. Because they typically trade at a premium, rates have to rise quite a bit before their value dips below par.
But there are other risks. If rates do fall and the bond is called, the long-term investor receives his principal back precisely when he does not want it: a low-yield environment.
This is called reinvestment risk, and it can hurt the return on your overall portfolio.
Moreover, while the continuous kick in yield might look appealing, the chances of this happening might be slimmer than anticipated.
“The yield to call will definitely happen, but the yield to maturity may not,” said Loop Capital’s Chris Mier.
He said if you went looking for all the 30-year maturity bonds issued 20 years ago with a 10-year call, you wouldn’t find much. That’s because once the bond becomes currently callable, the only incentive an issuer needs to exercise that call is one sustained drop in yields.
“The people that give too much value to the kicker, to the yield-to-maturity,” Mier said, “are fooling themselves if they think there is a high probability that they are actually going to get to maturity.”
