Explaining Callable Bonds - Term Paper Example

?Introduction Generally when a company want to get external funding, it uses different ways, one of them is to issue bonds. As explained by Frykman and Tolleryd a bond is straightforward investment tool. Bonds attract interest until their expiration date and have specified lifespan (173). Because of their nature bonds, are generally simple and safe. However, we have different types of bonds, and one of them is callable bond, which differs slightly with regular bond. According to Frykman and Tolleryd, callable bonds consist of “double life” thus, they are complicated compared to the regular bond and investors have to be more careful when investing in them (173). There are different reasons as to why companies issue callable bonds, as noted by Frykman and Tolleryd, one of the reasons as to why companies issue callable bonds is because of their hedge interest rate (173). The point is that, the moment interest rates reduce, the issuing companies can then repay the bonds at lower interest rates. This paper aims at examining callable bonds. Overview As explained by Le callable bonds allows those borrowing the option of re-investing if the interest rates reduces (4). This implies that companies are able to hedge against likely reduction of interest rates in future. It is because of this aspect tha makes callable bonds to be prefered by many investors particularly before 1990s. In deed, before 1970, nearly all companies issued bonds that had were callable. But, as from 1970 to 1990, callable bonds being issued reduced to about 80%. This was attributed to developents that had taken place within the interest rate derivaive markets over that period. Presently, the number of callable bonds on the market has greatly reduced accounting for less than 30%. According to Le the reason for this reduction is the fact that, it has become easier for companies to hedge against the interest rate risks (4). Explaining callable bonds When a company issues a bond, it has to make a critical decision regarding the type of bond it will issue, if it will be a callable bond or a regular one. In defining a callable bond Brigham and Houston states that callable bond, also known as redeemable bond is a kind of bond that permits the issuing firm to retain the benefit of trading in the bond at a certain time before the maturity date (220). This implies that the issuing firm retains the right of buying back the callable bond, though it is not obligated to do that. Basically, the bonds are not in actual sense bought back by the issuing firm; rather the firm cancels them immediately. When recalling the callable bonds, the issuing firm has to pay more than the par price. In some cases, for example in high-yield debt industry, the call premium could be considerable high. Therefore, the issuing firm has a choice, of either paying a higher premium or waiting until the bonds mature. Brigham and Houston notes that supposing the interest rates prevailing in the market go down at the time of calling back the bonds, then the issuing company will be in a position to refinance its debt cheaply (220). Accordingly, as the interest rates reduce, the value of the bonds increases, thus, it is beneficial to re-buy the bonds at their par value. When callable bonds are used, the investors are given the advantage of a higher token or value, as opposed to what they have gained with regular bonds. However, when the interest rates reduce, the issuing firms will likely recall the bonds and just invest them at interest rate is low. The moment a company has recalled the bond, the company can as well reissue the similar bonds at a much lower interest rate. This process of reissuing bonds to save money on the interest payment is referred as refunding. Brigham and Houston notes that before the bonds are recalled, the bond holders are informed by a letter, one of the agreements when investing in a callable bond (221), is that the investors agree that the bonds can be bought back and the investors should be ready to sell the bonds. However, companies recalling the bonds can as well advertise the “recall” of the bonds through major financial publicans as a way of notifying the bondholders. In generally, callable bonds provide interest benefits in the same way as the normal bonds, however, the bond issuer retains the right to pay back the bond supposing the interest payment goes up too fast beyond the agreed rate. Thus, the bond issuer has the advantage except if the bondholder has the insight information and timing to sell their bonds to other bondholders before they have recalled. Features of callable bonds Callable bonds, which are debt securities has a changeable life, and their value, since they are recalled. The call period is not set at a certain particular time and can be done on multiple occasions. The interest for the bond sold by the investor is included in the bond through higher interest on callable bonds or by their low values. Figure1 showing the behavior of callable bonds The callable bond might be traded at a price that is more than the call price, however it will be below a narrow difference of interest rates in case the interest rate goes below certain threshold level. Hooke explains that transaction expenses together with other corporate capital issues may permit bond value to remain slightly over its call price (56). With possible shortening of the callable bond’s life, the reduction in bond price for the bonds will raising interest rate would be minmized. Howeve, as noted by Le when the reduction in interest rate is substantial, the possibility of being recalled increases so that the prices of the bond may reduce as well (2). Yields of callable bonds Investors prefer to think in relations of what a bond will yield when mature because it is simple ti undertand. For instance a bond that trades at a yield of 6% is more easier to understand compared to 94.26% of its face value. In this regard, markets have formulated yields to evaluate callable bonds. Basically, yield to maturity ought not be an issue with regard to callable bonds. This is because callable bonds do not have a particular maturity time. For instance, the 10 NC 5 bond (that has to mature after 10 years but can be callable upon 5 years). Supposing the company that has issued the bond choses to recall the bond when it has reached 6 six, then the maturity of that bond will be 6 years. Nonetheless, the company can as well decide to leave the bond to reach its maturity period of 10 years. Since the callable bond does not have a particular maturity date, one cannot be sure of the movement of cash flows, and thus not possible to calculate the yield to maturity. Nonetheless, investors like yield measures and therefore two approaches have been formulated to calculate the callable bonds. First, it is assumed that the callable bond, will remain callable through its whole life. For instance in the above example of 10NC 5 bond, it implies that the bond will be mature after 10 years. Thus, the yield calculated under this postulation will stll be referred as yield to maturity. Secondly, it is assumed that the callable bond will be recalled at any time after 5 years. Thus, in the case of a 10 NC 5 bond, it implies that wil at least mature after 5 years. Calculating yield to maturity implies that the bond be recalled at anytime upon reaching 5 years. However, since the bond can be recalled at different points the calculation will as well differ in regard to the calling time. Why do companies issue collable bonds Having explained collable bonds, the important question is to understand why companies issue these bonds. According to Hooke, the most general explaination as to why companies opt for callable bonds is because of the hedge interest rate risk (56). The underlaying reason is that the moment the interest rates declines, the issuer can then refund or recall the bonds at a much lower interest rates (Hooke, 56). However, Le in his obervations notes that, the above reason is hard to explain (2), since emprical studies have shown that majority of companies do not refund their bond upon recalling them. For instnce (Hooke, 56) reported that about 75% of bonds that are recalled by companies are not refuunded. How then can companies benefit from the lower interest rates without the refund? In essence, if a company is ready to borrow funds at higher interests of say 9%, when issuing its bond, how comes that the same company will be unwilling to borrow at a lower interest rate, for example at 7%, by recalling its bond. Thus, there are some more factors as to why a companies that issue callable bonds do not recall them. Recent studies This sectiion aims at examing recent studies regarding callable bonds. From the studies, the paper will examine a recent model formulated by Zeng et al on firms ex ante (prio) choices that it can take before the issuing callable or non callale bonds. There is is also ex post (after) decisions on if the company should recall the callable bonds, and if it should refund themupon the recall. In this regard the formulated concept explains the current emprical results in the present study, for example absence of refunding of recalled bonds by companies. In addition,the concept as well provides different premises that can be further be rexamined in other studies.s. Recent studies by Chen et al have suggested that equity-value maximizing companies requires to get funds to invest in present projects and probablly in future project (3). Thus, in their they suggested that a current project of a company will have a positive Net Present Value (NPV), however,for the future project, the present value is not known, and it could be positive or negative. If such a company decides to issue a bond to investors, it could be callable or non-callable. Upon the present project generating a cash flow, the company and the imvestors will undertake more analysize on the future project. Basing on the new data and information, the company will therefore decide if it should invest the money in the future venture or if this will be a bad move. Since the company aims at capitalizing on its equity value, the decision regarding the investment might be unsuccessful supposing the bond is non-callable. More particularly, Chen et al explains that the company may wish to invest in venture that has a negative NPV, though with high risks (2). This could be because even though investing in such project will reduce the company’s value, the bond value will as well be lowered, and the bond holders can observe the difference. Proejectting such a situation, the investors would end paying lower price when it issues the bond, as opposed to if the company would have commited it funds to a more successful project. As noted by Chen et al this is a well estabihed risk-shifting issues that has been studied before by other scholars (2). Thus a company may issue a callable bond with the objective of reducing the risk-shifting issue. The important aspect in this respect is that a callable bon offers the company a choice to lower its debt responsibility supposing it establsihed that the future venture it has invested in has a negative NPV. Even if the company had issued non-callable bond, the company may still wish to continue with the project. Nonetheless, supposing the company has a choice to re-buy the bond at a reduced value that its par value, the company may be motivated not to continue with the planned project that has a negative NPV and instead recall the bond. This is because the debt responsibility would have been reduced and the company can thus keep a biger part of the company’s value, a lot of which would have been taken up by bond holders in cases of non-callable bond. Thus, as Chen et al puts it, a callale bond basically allows the bond holder to drive the company into investing in a susseful investment project (3). Nonethess, it has been noted by Brigham and Houston that there is cost involved with issuing of a callable bond (221). Supposing the future venture ends up being successfully, the company would go ahead and invest in that project. However, when the project is thought to be very sucessful, the company may as well desire to recall the bond and give a lower refund. But, as pointed out by Brigham and Houston the company will have to incur extra cost of refunding (221). Thus, a company is faced with the underlined tradeoffs when it chooses to issue callable or non-callale bonds. The beauty of a callable bond is its abiliy to reduce the company cost of debt in a situation where a company invests in a bad project. On the other hand, if the project is good, the only cost that the company will incur will be refunding cost. This means that companies that expect to have a good investment would possibly issue non-callable bonds, while those who project that their investments may be bad would issue callable bonds (Chen et al 3). The model proposed by Chen et al as well characterized the company’s behavior upon issuing a callable bond (3). To begin with, supposing the company establishes that its future venture is bad, it would avoid investing in that venture and recall the bond but also decline to refund it. Accordingly, Brigham and Houston offers to explains this aspect (233). Secondly, supposing a company established that the future venture is bound good, the company would pursue the project, recal the bond, then, offer a refund at a lower expense. Lastly, when a company estanlsihe that the future venture is average, it will decide to undertake the venture without recalling the bond. As pointed out by zeng this is because of the positive NPV of the venture and secondly, the cost of refunding the bond would be higher than the amount obatined from recalling the bond. In analysing this finding and, a number of testable premises can be established, that can be tested against the current literature on callable bonds. Accordingly, in the ex ante (prio) study, the relationship between a company’s decision on whether to issue callable bonds or non-callable bonds in respect to the projected future investments is made. The major expects to examine include the leverage ratio as well as the investment risk. In second part of ex post (after), the aspect to be examined is the relationship between a company’s present investment performnce as well as their decisions on if to call back the bonds or if the company should refund the callable bond. After examing these two aspects, Chen et al found out that they was a strong empirical evidence supporting their model (3). It was established that companies expect bad future investments chances and companies with higher leverage ratios coupled by investment risk are most likely to use callable bonds. Since companies recall their bonds, companies that have poor performance and with low investments are unlikely to refund their callable bonds. On the other hand, companies with good performance and with many investments projects are likely to offer a refund. Finally, companies with average performance and few investments projects are also unlikely to recall their bonds. This findings are as well economically important, it is projected, for instance that a rise in one standard deviation occuring in the market ratio (alternative for future business investmets) relates to a 35% reduction in the company’s possiility in issuing a callable bond as opposed to issuing a non-callable. More so, it is important to note that companies that recall their bonds, or do not refund their bonds are linked with poorer performance as well as lower investments in projects. A reduction in one standar deviation for example its ROA will correspond to a decrease in the company’s possibility of refunding its recalled bond. However, there maybe variations in some situations in regarding these observations. Theories explaining reasons for callable bonds The fourth reason is based on “removing restrictive covenants theory.” This theory posists that callable bonds enables a company to do away with unwanted restrictive agreements related to bond inorder the company can be involved in other activities that would have not been possible to be undertaken. The final reason is based on that fact that callable bonds lowers the risk-shifting problem a company faces. Shareholders can obtain some profits from bond holders by the company investing in more riskier businesses. Brigham and Houston explains that since the call option interest of callable bond reduces as the company value reduces (224), shareholders of a company will not be willing to transfer their earnings, this is what is termed as “reducing risk shifting theory.” However, the model formulated by Chen et al that has been discussed in this paper varies with the above five theories (3). The first difference comes from the fact that the model by Chen et al offers a reason as to why a number of companies provide a refund upon recalling their callable bonds, and while other companies do not offer the refund (3). The second difference, is that the model by Chen et al formaaly examines the a company’s trade-off on whether to offer callable bonds or non-callable bonds (3). Generally, the study made by Chen et al provides three significant contributions to existing literature on callable bonds (4).one, this model derives a company’s balance on if to offer callable or non-callable bonds, if the company should recall the bonds and if it should give a refund or not. Two, this model gives emprical results that are inline with other past theories. Three, the model formulated by Chen et al is among the very few recent studies to examine a company’s commitment towards paying a refund on callable bonds when experiencing poor performance. Conclusion This paper has discussed in length callable bonds and to some non-callable bonds. As noted callable bonds can be re-bought the the insuing company even before the maturity date reaches, while the non-callable have to mature. From this discussion, if a company offers a non-callable bond, though the company’ investment opportunities may end up being, the company may as well still be motivated to invest in other projects due to the widespread risk-shifting issue. The paper as well examined a model proposed by Chen et al, on callable bonds, which argues that a company can use a callable bond in lowering the risk-shifting problem. This is due to the fact that call option allows a company to lower its debt responsibility supposing the company investements ends up being unsuccesful, this is advantegeous for shareholders particularly where the company is having a a negative NPV. Nonetheless, those companies that offer callable bonds have to pay a refunding cost incase the investments made end up being very successful. Thus, a company has balance between the cost and reducing risk-shifting problem, and decide if it will have to issue callable or non-callable bonds. Works Cited Brigham Eugene and Joel F. Houston :Fundamentals of financial management:South Western Educational Publishing. 2008 Chen Zhaohui, Connie Mao Young Wang: Why Firms Issue Callable Bonds: Hedging Investment Uncertainty. 2007. Accessed 9/5/2011 Frykman David and Jakob Tolleryd:The Financial Times Guide to Corporate Valuation (2nd Edition) (Financial Times Guides) Publisher: FT Press. 2010 Hooke Jeffrey: Security Analysis and Business Valuation on Wall Street : A Comprehensive Guide to Today's Valuation Methods: 2 edition.Publisher: Wiley; 2010. Le Anh: Callable bonds:2008. Accessed 9/5/2011 Read More