by Steve McDonald, Bond Strategist, The Oxford Club
Monday, October 8, 2012: Issue #1877
That’s the only way to describe what’s going on in the corporate bond market.
Historic low interest rates have created an unprecedented opportunity for capital gains from what has traditionally been an interest-bearing investment only.
The frequency of called and tendered corporate bonds is exploding. Companies are racing to refinance as many bonds as they can while rates are at ridiculously low levels, and bond owners are reaping the benefits.
Taking Advantage of Calls
Calls are written into bonds to give the issuing company a “get out of their obligation early” option. It just makes sense for a company that has the cash or credit to call (buy back) a bond before maturity if the company can reissue it at a lower interest rate. In this market, rates are so low that everyone who can call is calling their bonds. The interest savings to the company can be huge.
It’s no different than the savings you see when you refinance your mortgage.
Calls are a great deal for bond owners, too. Returns on called bonds can be through the roof!
Here’s an example of a bond with a call that will increase a bond holder’s annual return by more than double.
Alion Science and Technology has a bond with a 12% coupon that you can buy for about 96, or $960.
If held to maturity, November 1, 2014, this bond will pay an annual return of about 14.5%. That’s a great return in anyone’s book, but it gets better…
The Alion bond has a call in April of 2013 at 105. That means the company has the right to buy back this bond on that date at 105, or $1,050. That’s for a bond you can buy now for about 96, or $960.
If the bond is called – keep in mind that not all are – the holder would earn an annual return of 32.5%; more than twice the annual return if the bond were held to maturity… Twice!
Most brokers will tell you calls are a negative because you won’t receive the 12% coupon, which on a cumulative basis could pay you more over the life of the bond. I say, if they call the bond, take the money and run. I have been at this game too long not to take free money, and calls are exactly that – free money.
If Alion wants to give me $1,050 for a bond I bought for $960, a full year and five months before they have to give me any principal, I’m all in!
In this market calls are not only good for the wallet, they also get you out of the market sooner. If you’ve been following my bond work, you know that’s a big positive. The shorter the maturity of your bonds, or the less time you have your money in the market, the less the effect of inflation and the less the market value fluctuation in the event of a sell-off. In this market a short-term exposure strategy is essential.
Replacing a 12% bond will be difficult in this market – rates are dropping as I write this – but I think of calls as money in the bank. I’ll worry about getting a new bond after I have Alion’s money in my account.
Profiting From a Tender Offer
Tender offers, another unique quality of bonds, are also popping up everywhere and are just as profitable as calls.
A tender offer is when a company wants to buy back a bond before maturity but doesn’t have a call written into the bond contract or the call date they do have is several years down the road. It’s sort of a surprise call.
From an owner’s perspective, one of the nice parts of a tender is that the bond holder doesn’t have to accept the offer. This is one of the many situations where bond owners are in the driver’s seat. The owner may choose to refuse the offer and keep the bond. The company cannot force you to give up your bond.
But, tenders are usually very profitable. A company stands to save a lot of money on future interest payments, so the tender offer has to be pretty sweet to get a bond holder to give up his bonds and the interest he would receive.
Tenders can also have an early and final offer. The early offer pays a higher dollar amount than the final in an effort to get as many bond holders to commit to the offer as possible. The company wants to get this bond out of circulation and is willing to pay up to reduce its costs. Every day it’s out there costs the company a lot of money.
Massey Energy’s Tender
Here’s a bond I recommended in my Oxford Bond Advantage trading service in early July that recently had a tender offer.
Massey Energy has a bond with a coupon of 3.25% – not much of a coupon, really – that matures in August of 2015. We purchased the bond for 88, or $880, on July 8 of this year. So we’ve held it about two and a half months.
Massey’s early offer is $940 for the bond if you accept the tender offer by October 11. It also has a later offer at 92. Why anyone would wait for the later offer is beyond me.
My recommendation to my readers was to accept the early offer. Here’s how the numbers worked out…
The 94 offer will pay us a $60 capital gain, and we receive accrued interest from Massey for the entire time we’ve held the bond.
This idea of accrued interest is unique to bonds. Dividend stocks only pay a stock holder if they hold the stock on the ex-dividend date. Miss it by one day and you get nothing. Bonds pay you from the time a bond shows up in your account until it’s called, tendered, sold, or it matures. It’s a very nice benefit.
In the case of the Massey bond the coupon is so small, 3.25%, the accrued interest isn’t much, about $5. But it’s their five dollars we’re getting.
More Free Money!
A $60 capital gain plus about $5 of accrued interest, divided by our cost and our holding time, $880 and 2.5 months, times 12 for the annual yield.
60 + 5 / 880 / 2.5 x 12 = 35.45%
That’s an annual return of 35.45% from a bond that will only pay us 3.25% to maturity. You have to take an offer like that.
Businesses will continue to call and tender bonds as long as it’s cost effective to do so. If rates stay low – and they look like they will for at least three more years – expect the flood of refis to continue. It just makes good business sense.
Bonds have always been the perfect place if you’re looking for a more secure and predictable return than the stock market. The current interest rates make them a great place for unexpected capital gains, too.
Take the money and run!
SteveCorporate Bonds: Take the Money and Run,