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In this edition of 9fin educational, we take a look at the range of redemption clauses in HY bonds and the trends that favour issuers and sponsors.

First, as a bit of background, HY bonds, unlike traditional loans, contain a “non-call” period, during which the company can’t (with a few exceptions discussed below) redeem their outstanding bonds without incurring a penalty, known as a “make-whole premium”. The idea is that investors in bonds typically don’t want their money back early, instead they want a stable stream of income (the coupon payments) until maturity. As a result, the “non-call” period in fixed rate offerings is typically set at two years for a bond with a five-year tenor (expressed as 5NC2), and three years for a bond with a seven-year tenor (7NC3). Floating rate offerings, due to their nature, typically only have a non-call period of one year, regardless of tenor.

But why would an issuer want to repay its bonds early? They may do this for a range of reasons - but the most common is simply to refinance the notes as maturity approaches. The issuer is also incentivised to do this if its notes are trading well suggesting a cheaper coupon is available, or to opportunistically extend its maturity wall. The redemption of outstanding debt can be a condition of an acquirer’s financing agreement. Finally a company may redeem its outstanding bonds to simply pay down its debt levels and de-lever if it has excess cash.

Make-Whole: Salve for Investors’ Hearts

As mentioned above, during the non-call period, the issuer may still redeem its notes using the make-whole (or under certain other exceptions described below). The make-whole redemption price is calculated as the sum of the principal amount of the notes, plus accrued and unpaid interest, plus the make whole premium.

The make-whole premium (or sometimes called the “Applicable Premium”) is equal to the greater of:

(a) 1% of the principal amount of the outstanding bonds, and

(b) the net present value at the redemption date of the redemption price that would apply at the first call price plus remaining coupon payments through to the first call date (i.e., to make investors “whole” for any lost coupon payments they expected to receive), using a discount rate that is typically the yield to maturity on a comparable government security (US Treasury, Bund or UK Gilts) plus a small margin (customarily 50 bps) and less par. Note that some deals include a 0% floor on the discount rate applied - this is in favour of the issuer as it wants a positive discount rate to reduce its net present value calculation.

Following the expiry of the “non-call” period, bonds contain soft call schedules which give issuers the option to redeem their outstanding bonds at par plus a percentage of the coupon. This percentage step-downs each year thereafter until the bonds can be redeemed at par.

It is important to keep an eye on the call prices as the lower they are the more likely a bond will get redeemed, meaning bondholders may need to hunt for a new credit to invest in. This is even more important in a falling interest rate environment as it becomes harder for investors to find equal-coupon paying notes at the same risk level - however, the inverse is true in an environment where interest rates are increasing, such as now, and investors may find themselves stuck in a bond with a lower yield than they could get elsewhere - but such is life.

The following is an illustration of a typical 5NC2 call schedule for fixed rate notes, based on 888’s 7.558% fixed rate senior secured notes due 2027. They are non-callable until 15 July 2024, and then callable at par plus 50% of the coupon, decreasing to par plus 25% in 2025, and to par in 2026 and thereafter. The 50%/25%/0% premium is the standard formulation for five-year fixed rate notes (you would add an additional 12.5% level if it was a seven year non-call three bond).

888’s 7.558% SSNs due 2027 call schedule

It’s also worth noting that certain sustainability-linked bonds sometimes include an additional premium on top of the standard call premiums discussed above where a company fails to meet its sustainability targets. For more information on this, see our separate write-up here.

As mentioned previously, floating rate notes follow a different format for their call periods, they are typically non-call 1 (NC1), meaning they can’t be called during their first year. After that, the call price is typically set at 101%, although we have seen examples of other call prices being used. In the following links we have pulled together lists of FRN deals where we have seen 100% and 102% first call prices. Note some of these fall outside of what might be considered the standard HY universe (or may not be NY law governed).

Historical Trends in Tenors, Non-Call Periods and Call Premiums

Fuelling the 2021 refinancing craze was a combination of decreasing tenors, tightening non-call periods, and cheaper premiums. It’s always difficult to say why bonds contain mechanisms that operate in a specific way, for example, why should it be non-call for two years, and then callable at par plus 50% of the coupon rate? The answer is, with most things in the HY universe, it’s just what has slowly become market standard, but this doesn’t mean it was always this way. Below we go through tenors, non-call periods and premiums to show their trends since ~2010.

Over the last decade, we have witnessed the preference for a seven-or-eight year tenor shrink to five-years, increasing the need for more frequent refinancing and shorter-term capital structures. Ultimately, this means that investors have more turnover in their investments, but it also means issuers more frequently need to tap the capital markets - which they found favourable in a falling interest rate environment.

We may start to see tenors increase on average now that interest rates are rising, however nothing currently jumps out from the data 9fin is tracking. Perhaps issuers will decide to stick with the shorter lengths tenors in hope that rates will fall by the time refinancing comes around. A cheaper but riskier play.

To highlight the change in market sentiment, we took a look at debt levels trading to call. Bond prices that are performing well may imply a company can achieve cheaper financing and will call the bonds at the earliest date, while poorly performing bonds are likely to stay outstanding until maturity. In September 2021 9fin tracked around €40bn of debt that was trading to call or maturity before the end of 2021. Now, you’d have to extend the timeline out to the end of 2024 to get anywhere near that number. We currently track €32bn of debt trading to call or maturity before the end of 2024.

Furthermore, across tenors, we have witnessed the shrinking of non-call periods in favour of the issuer. Below are a few charts that illustrate the shrinking non-call periods. This is interesting because it results in cheaper redemption premiums earlier for the issuer, which ultimately increases the level of call risk for bondholders.

Source: 9fin.com. As a brief side note, 5NC1.5 deals have historically signalled a peaking credit market.

In addition to pulling forward the call schedule to make it available earlier, issuer’s are increasingly reducing the call premium payable at each call date. The following chart shows, for 2009-2015, and for 2016-2021, the percentage of deals with a 50% of coupon first call premium increased dramatically, and the share of deals with no third call premium at all dramatically increased too.

All of this demonstrates the trend, in favour of issuers, towards shorter bonds, with tighter and cheaper call premiums.

In addition to the basic call schedule outlined above (which only applies after the non-call period expires) and the make-whole, there are a number of options under which the issuer can redeem its notes during the non-call period. Notably, these options are typically only available for fixed rate notes - given that floating rate notes typically only have a non-call period of one year anyway.

First up, the equity claw. This usually allows the issuer to redeem up to a set percentage (typically 40%, increased over time from 35%) of the principal amount of the notes with the net cash proceeds from specified equity offerings at a redemption price equal to par plus the coupon rate.

Unusual claw terms may signal future IPO or exit plans from the owners. For example, The Very Group could use an equity offering to redeem all of its notes at 102%, lower than the usual par plus coupon, for up to one year after its notes issuance. The group reportedly revived its IPO plans in May 2022.

What counts as an "Equity Offering" for purposes of the equity claw may be broader than bondholders realise. It can include private sales of equity or even sponsor-funded new equity. In addition, the redemption usually needs to occur within 180 days of the relevant offering, but this is sometimes getting pushed out to 270 days (e.g., Medline Industries and Athenahealth).

As mentioned at the start, historically a set percentage of notes had to remain outstanding after using an equity claw - this was typically just 100% less then amount you could redeem using the equity claw. This meant that if an issuer desired to redeem all of the notes during the non-call period, investors would be entitled to the full make-whole.

However, drafting has evolved in recent years to decrease the percentage of notes required to remain outstanding (to 100% less max claw amount less 10%, i.e., 50% rather than 60% - but note this is really just accounting for the 10% at 103% feature discussed next) and in some deals, this requirement falls away completely if all of the remaining bonds will be redeemed “substantially concurrently”. This latter language, where present, allows the issuer to use the equity claw together with the make-whole redemption and the 10% at 103% feature if present (together a “blended make-whole”) to redeem all of the notes, achieving potentially significant savings versus a full make-whole redemption price.

Over time, the equity claw has become more popular and increasingly lenient. Now seen in almost 90% of all tranches, the equity claw typically allows for redemption of 40% of the notes, compared to 35% in the early 2010s. The following graphics demonstrate the increasing prevalence of the equity claw, and percentage of notes that can be redeemed using it.

10% at 103% - because it just makes sense.

The 10% at 103% feature allows issuers to redeem up to 10% of the outstanding principal amount of the notes at a redemption price equal to 103% during each 12-month period from the issue date - note that this is only available during the non-call period.

First introduced by Expro in December 2009, this feature saw some tinkering early on. Some deals, such as CEVA’s SSNs issued in 2012, included a redemption option for 10% at 105% in each 12-month period, but as the feature has aged it has become commonly known and seen as 10% at 103% - note this redemption price is completely unmoored from the coupon of a particular tranche.

The option has become more common in high yield, especially in sponsored deals. Even if an issuer wants to redeem a larger portion of its notes, it can use the 10% at 103% first (or simultaneously) and then pay the more expensive call premium for the remaining redemption (whether that’s the equity claw or make-whole).

This concept featured exclusively in secured tranches for the first few years, however it has begun to creep in to unsecured deals as well. At 4.8%, 2021 saw the highest percentage of unsecured deals with the feature. Not particularly alarming, but if the above trends are anything to go by, this number is likely to increase going forward.

There are a few more redemption options, which become a bit less interesting, as they are more niche and only apply in specific transactions and situations, but worth mentioning for completeness.

One often-overlooked option for issuers is its ability to simply buy their bonds in the open market. The difference between this option and the others outlined above is that the issuer is not able to require someone to sell them their bonds, they are simply buying what is available for sale. This does allow them to take advantage of dipping bond prices, but again, they need to have cash available to do this. Any significant purchase volumes would have an effect on the price in secondary and issuers need to be wary that if they buy too much on the open market they could fall foul of tender offer rules in the US.

Bonds always require amounts payable by the issuer or guarantors to be made without withholding or deductions for taxes - unless it’s required by law. However, deals are always structured so that no such taxes apply, at least on day one, to the issuer or guarantors. If an issuer or guarantor does indeed need to withhold or deduct amounts for taxes, it has to top-up the amount it ultimately pays to investors such that they do not receive a reduced portion, known as a “gross-up”. In the event tax laws are changed (and therefore tax deductions would then be required), the documentation contains a redemption option for the issuer to redeem its notes at 100% of the principal amount plus accrued and unpaid interest (but no make-whole), allowing it to avoid the “gross-up” it would otherwise be required to make. The obvious limitation here is the issuer’s access to cash to make the redemption.

This isn’t really a “redemption” option like the others, but the change of control (CoC) put option mandates that issuers make an offer to repurchase all outstanding notes upon the occurrence of a CoC. Investors then have a choice between accepting the offer or not. Customarily the put price is 101%, however 100% has been seen from outliers such as Smurfit Kappa and Softbank.

Issuers undergoing an LBO or similar may actually want to repurchase the notes at 101% if they think they can refinance more cheaply, but depending on how the bonds are trading, and expectations for the new paper, investors may or may not take the offer. For more detail on change of control, and portability in particular, see 9fin’s educational piece on Change of Control here.

If you need to quickly review the redemption mechanics on a particular transaction, what should you look out for? The following is intended to be a short list to help you focus your review on the key points.

Consider the call schedule, when are the bonds first callable? What are the step-downs? If the notes are trading well it is likely in the issuer’s interest to refinance the notes in the short-term.

What is the cheapest way for an issuer to call the notes and how do the redemption mechanics facilitate this - considering that they could take a “blended” approach, including open market purchases.

Consider the issuers sustainability-linked targets, if any, and whether they impact call prices.

Does the equity claw suggest that a future IPO or sale is on the table?

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