In recent years, the make-whole call has become commonplace for taxable bonds, including municipal Build America Bonds.
Around 7% of roughly 50,000 corporate issues and about 13% of 10,000 BABs have this provision, which allows early redemption at a price based on the yield of a maturity-matched Treasury bond, although usually not below par.
How much does the market charge for a make-whole and is it worth it to the issuer?
To appreciate the workings of the make-whole call, a brief historical perspective may be helpful. The genesis of the early redemption provision was the fixed-price call.
Suppose that a plant generates sufficient revenues to service a bond issue, but then suddenly burns down?
Insurance pays off, but the borrower must continue to service the debt. Redeeming the bonds at a known price provides a convenient solution.
However, the original fixed-price call had an unintended benefit to the borrower, who could take advantage of declining interest rates by calling and refunding.
This was to the obvious detriment of the investors, and they responded by requiring a clear distinction between redemption to satisfy some corporate objective, and refunding to reduce interest expense. They demanded a higher yield when buying bonds that were both callable and refundable than for those that were callable but not refundable.
The obvious intent of “callable but not refundable” was to protect the investor from reinvestment risk. But a well-documented court ruling made this distinction meaningless.
In 1983, Archer Daniels Midland called high-coupon bonds using the proceeds of an equity sale, and issued lower-coupon bonds shortly after. Investors were outraged and several lawsuits ensued.
But money being fungible, ADM prevailed — it could not be established that this was effectively a refunding at lower interest rates.
Although ADM was reportedly “punished” by investors in later bond offerings, the lesson was that the “callable but not refundable” feature did not provide them protection against having their bonds called away in a lower rate environment.
Nevertheless issuers continued to need an out in extraordinary circumstances, such as a corporate takeover requiring the extinguishment of bonds with negative covenants.
Borrowers developed the make-whole call to avoid paying the higher yield associated with the fixed-price call option while still retaining the option to retire the bonds.
The call is so named because it makes investors whole by paying a redemption price above fair value.
A make-whole price is obtained by discounting the remaining cash flows at the maturity-matched Treasury yield plus a small spread.
The Southern California Edison 5½’s of 2040, for example, have a make-whole call of T+15bps. At the time of issue, they traded at a 90 bps spread to the 30-year benchmark Treasury.
Regardless of interest rate movements, the make-whole call price would be substantially above the bonds’ fair value. Thus, the investors cannot be harmed from a make-whole call unless the issuer’s credit spread improves to within 15 bps of Treasuries — a highly unlikely event.
Extreme market conditions can produce exceptions. In April 2009, Verizon issued 6.35% bonds maturing in 2019 at a whopping 387 bps spread to the 10-year Treasury.
The make-whole call at T+75 bps appeared innocuous at the time. But after the credit crisis abated and Verizon’s spreads tightened considerably, it is conceivable that the bonds will be called below fair value.
Under certain circumstances, exercising a make-whole call may make economic sense for taxable corporations, because the premium is immediately deductible for tax purposes.
Fortunately this benefit to the issuer is not at the expense of the bondholder. Since municipalities do not pay taxes, this has no relevance to BABs.
The make-whole call provides a legal exit for an issuer in circumstances unrelated to interest rates.
It allows the premature redemption of bonds, but at a price that is guaranteed not to hurt investors (who are essentially more than made whole).
Consequently, investors do not demand a yield premium, as they would for bonds callable at a fixed price.
In a sense, the make-whole takes us full circle to the original intent of the call option.
Andrew Kalotay is the president of Andrew Kalotay Associates. For more information on the history of make whole calls, he suggests “Corporate Bonds: Structures & Analysis,” by Richard Wilson and Frank Fabozzi.