When Eli Lilly & Co sold $4bn in bonds to pay down short-term debt last week, one of the tranches was a little . . . different.
Readers may be able to spot the quirk in the documents:
“Par Call Date” means, with respect to the 5.000% notes, February 27, 2024 (24 months prior to the maturity date of the 5.000% notes), with respect to the 4.700% notes, November 27, 2032 (three months prior to the maturity date of the 4.700% notes), with respect to the 4.875% notes, August 27, 2052 (six months prior to the maturity date of the 4.875% notes), and with respect to the 4.950% notes, August 27, 2062 (six months prior to the maturity date of the 4.950% notes).
One tranche can be repurchased by the company three months prior to maturity, all normal. Another can be called six months prior, which is also pretty standard . . . and then one is callable two years prior to maturity??
Yes, Eli Lilly will have the option to buy back its $750mn three-year bond after it’s been on the market for just one year. That’s two years before its scheduled maturity, according to our finger counting highly sophisticated calculations.
Callable bonds aren’t new, of course. Banks and junk-rated borrowers are big issuers of securities — in the US that’s in the form of preferreds and bonds — that can be redeemed early.
But investment-grade US companies normally sell bullet bonds, whose principal is repaid in one slug upon maturity. In 2021, higher-rated companies started selling more bonds with the callable structure found in Eli Lilly’s sale, according to CreditSights. And they’ve been selling more this year for reasons we will explain (mostly rising interest rates). See this nice chart, with our apologies for the slightly blurry text:
The industry shorthand for this type of bond is a “3NC1”, meaning a 3-year bond that is Not Callable for 1 year.
To state the obvious, these structures do not give bond investors/lenders an advantage over borrowers. If an early redemption would be profitable for bondholders, there’s no reason for the company to do it and use up cash that could otherwise go to shareholders or operations. Put simply: Nobody wants to give their lenders extra money if they don’t need to.
“As an investor you’re short that call, the [borrowers] have the optionality,” said Anthony Woodside, head of US fixed-income strategy at Legal & General Investment Management America. For “a lot of those deals, we have not been, in our opinion, compensated enough to participate.”
The 3NC1 bonds are getting sold this year anyway, he added. With the yield curve inverted and the Federal Reserve’s policy rates higher than they’ve been in ~15 years, demand is high for short-term bonds, and recession worries are pushing investors into the investment-grade market. So companies (and their bankers) are correctly betting that investors will take the risk for some extra short-term yield. Here’s the list of 2022 and 2023 bonds, also via CreditSights:
For bond investors like Woodside, the most important question is whether the company is paying enough to make up for the risk that the company will choose to redeem the debt and force them to reinvest that cash in a year, or keep the debt outstanding and prevent them from investing in new 2-year bonds at potentially higher yields. That compensation has averaged 20bp to 25bp in extra price discounts, according to CreditSights, on top of the standard price concessions needed to attract buyers today.
For investors who buy 3NC1s, some additional appeal may be found in the embedded bet against volatility. Put differently, owning the bond is also betting that borrowing costs won’t fall so low (or rise so high) in a year that the company will find it especially beneficial to call the bond and refinance (or, at least in theory, not call the bond and keep a lower coupon than they would get otherwise).
The borrowers get an arbitrage opportunity from the structure, says CreditSights. For example, General Mills said in its latest quarterly filing that it has converted its fixed-rate payments into floating-rate payments in the interest-rate swaps market.
To risk oversimplifying, the point of the arbitrage is to reduce funding costs by selling the bond’s embedded call along into interest-rate swap markets. The company pays a floating rate and receives a fixed rate (equal to the bond’s coupon), and receives some extra compensation for making the swap cancellable after one year.
This trade is simple and logical if yields fall over the next year: the company’s interest payments will decline, and the counterparty will cancel the swap as soon as it can so it doesn’t have to keep paying out the higher fixed rate. But that won’t matter, because by that point the company will be able to redeem its bonds and refinance them at a lower rate.
The arbitrage strategy isn’t without risk, though. If the economy crashes and burns, CreditSights warns, interest rates will plummet while credit spreads blow out, making corporate borrowing even pricier. That means the swap counterparties will want to cancel the trade, but companies would be stuck without a good option (or possibly even the ability) to refinance in bond markets.
And what if yields keep rising fast? Well, in that case the company won’t want to refinance its 3NC1, and its counterparty will bleed out its savings from the first year of the transaction. The counterparty could argue that the company would need to pay more if it refinanced in bond markets anyway, of course, but the arbitrage won’t look so good anymore.
That brings us to perhaps the biggest takeaway from the proliferation of the 3NC1 structure: It shows neither investors nor companies expect short-term Treasury yields to rise much farther. Indeed, the consensus in futures and swaps markets is that the Fed will raise rates to 5.25 to 5.5 per cent in late 2023 and cut in early 2024, according to Bloomberg data.
And if inflation continues to crank higher and the Fed embarks on a Volcker-style path of interest-rate hikes? Well, in that scenario, the outlook for 3NC1 bonds will be just one of many, many big problems in financial markets.
