Bond Pricing - The Problem With Premium Pricing

A Growing Trend

Does your bond issue have a yield “kick” or “kicker”? A recent growing trend in the municipal bond market is pricing long-term callable bonds at a premium.  This pricing approach has emerged due to a preference among certain institutional investors and, consequently, underwriters that sell bonds to these particular investors. 

What does this mean for investors? Under rules governing municipal bonds, callable premium bonds must be priced to the date resulting in the worst (lowest) yield for the investor.  Generally this means that the bonds are priced to the first call date.  This is attractive to investors because, in the event the bonds are not called, the yield to maturity will be much higher.  Furthermore, in a rising rate environment, premium bonds retain their value better than par or discount bonds.

What does this mean for municipal issuers? For cities, schools and other political subdivisions, premium pricing of callable bonds may result in higher total bond financing costs.  Issuers should be aware that premium pricing creates rates that are substantially higher than prevailing market yields. In addition, premium pricing of callable bonds may lead issuers to believe they received yields as low or lower than prevailing market yields when, in fact, the yields are higher. 

The yield "kick" refers to the difference between the yield to maturity and the yield to the call date. Because the yield to maturity is higher than the yield to the call date, investors receive a higher rate of return (the yield "kick") if the bonds are not called.  For the issuer, the kick results in a higher True Interest Cost (TIC)*.

Premium Pricing Basics 

Below are several tables illustrating the effect of premium pricing.  Each of these examples is based on a bond issue with the following characteristics:

  Maturity = 20 years
  Par Amount = $10,000,000
  Bond Yield to Maturity = 4.50%
  Underwriting Spread (Fee) =  1%  

The following table shows that when a non-callable bond issue is priced at a premium or when a bond issue (regardless or whether it is callable) is priced at par (100%), the True Interest Cost is essentially the same.

Comparison of Non-Callable Premium Bonds to Bonds Sold at Par

 

 

Non-Callable
Bonds Sold at
Premium


Bonds
Sold at Par

Rate on Bonds

4.65%

4.50%

Price Sold to Investors

101.964%

100.000%

Yield to Maturity

4.50%

4.50%

Amount Paid by Investors

$10,196,400

$10,000,000

Less Underwriter’s 1% Fee

     ($100,000)

     ($100,000)

Amount Paid to Issuer

$10,096,400

$9,900,000

True Interest Cost (TIC)

4.58%

4.58%

The following table shows that when a callable bond is priced to sell at a premium the price paid by the issuer (True Interest Cost) is significantly higher than on a non-callable bond. 

Comparison of Callable Premium Bonds to Non-Callable Premium Bonds

 

Callable Premium
Bonds

Non-Callable Premium Bonds

Call Date

8 years

Non-callable

Rate on Bonds

4.65%

4.65%

Yield to Maturity

4.57%

4.50%

Yield to Call

4.50%

na

Price Sold to Investors

100.998%

101.964%

Amount Paid by Investors

$10,099,800

$10,196,400

Less Underwriter’s 1% Fee

     ($100,000)

     ($100,000)

Amount Paid to Issuer

$9,999,800

$10,096,400

True Interest Cost (TIC)

4.65%

4.58%

From the issuer’s perspective, what do we learn from the above example?

1. When callable bonds are priced at a premium, investors pay the price based on the yield to the call date.  In the above example, the price to the call date is 100.998% compared to 101.964% if the bonds were not callable.  
 
2. The official statement for the callable bonds will show the bond prices and yields based on the yield to call.  Consequently, the issuer is likely to believe it received a very favorable 4.50% yield even though the yield to maturity is 4.57%.  Stated differently, an issuer will not be able to determine how its bond yields compare to other issuers unless it analyzes the yields to maturity.  
 
3. In the above example, the True Interest Cost is .07% higher for the callable premium priced bonds.
 

Premium Pricing Strategies for Issuers

Premium pricing increases debt service while simultaneously increasing the purchase price (funds available) to the issuer.  When an issuer requires additional capital and can afford to pay higher debt service, premium pricing can be a favorable pricing strategy. For non-callable bonds, premium pricing can be effective because the premium paid to the issuer increases proportionately with the rise in interest cost.  As a result the true interest cost paid by the issuer remains unchanged. This is demonstrated in the following table:

Premium Priced Non-Callable Bonds

 

Bonds with 4.65% Rate

Bonds with 4.80% Rate

Bonds with
4.95% Rate

Yield to Maturity

4.50%

4.50%

4.50%

Price Sold to Investors

101.964%

103.929%

105.893%

Total Amount Paid by Investors

$10,196,400

$10,392,900

$10,589,300

Less Underwriter’s Fee

        (100,000)

        (100,000)

       (100,000)

Amount Paid to Issuer

$10,096,400

$10,292,900

$10,489,300

Total Debt Service

$19,300,000

$19,600,000

$19,900,000

  Amount Paid to Issuer as a %
   of Debt Service

 
52.31%

 
52.51%

 
52.71%

True Interest Cost (TIC)

4.58%

4.58%

4.58%

In contrast, premium pricing is a costly approach when applied to callable bonds. As shown below, if the rate on the bonds is increased on callable bonds, the price paid to the issuer declines in proportion to the added debt service cost and the True Interest Cost increases.

Premium Priced Bonds – Callable in 8 Years at 100%

 

Bonds with 4.65% Rate

Bonds with 4.80% Rate

Bonds with
4.95% Rate

Yield to Maturity

4.57%

4.65%

4.72%

Yield to Call

4.50%

4.50%

4.50%

Price Sold to Investors

100.998%

101.996%

102.995%

Total Amount Paid by Investors

$10,099,800

$10,199,600

$10,299,500

Less Underwriter’s Fee

      (100,000)

      (100,000)

       (100,000)

Amount Paid to Issuer

$9,999,800

$10,099,600

$10,199,500

Total Debt Service

$19,300,000

$19,600,000

$19,900,000

Amount Paid to Issuer as a %
   of Debt Service

 
51.81%


51.53%


51.25%

True Interest Cost (TIC)

4.65%

4.72%

4.79%

From the issuer’s perspective, what do we learn from the above example?

1. Although the yield to the call date remains at 4.50% (which is the rate that would be shown in the official statement), as the rate on the bonds is increased the yield to maturity is progressively higher.   
 
2. In the above example, the increase in rates from 4.65% to 4.95% increases the True Interest Cost by .14%.
 
3. Due to the added cost of premium callable bonds, issuers may want to consider limiting the premiums on their callable bonds. Issuers will realize a True Interest Cost savings provided that the yield to maturity is no higher than the issuer would obtain with premium pricing.  For example, if the issue were priced at par with a yield to maturity that is less than 4.72% the True Interest Cost would be lower than for the issue above that has a rate of 4.95% and a yield to call of 4.50%.
 

Issuer Considerations

1. To determine how the yields assigned to your issue compare to those of other issuers, make sure you compare the yields to maturity regardless of whether the issues were priced with yields to the call date.
 
2. Working with your independent financial advisor, issuers should work to minimize premiums on callable bonds without impairing bond marketability.
 
3. Although restrictions that limit premium pricing may result in a different mix of buyers or fewer institutional buyers for the bonds, the issuer will realize a savings provided that the yields to maturity and True Interest Cost remain below the yields to maturity in a premium pricing model.
 

_________
*  True Interest Cost (TIC) is the cost of issuing a bond, taking into account both the underwriter’s fees and the interest rate.  TIC measures the cost in present value (time value of money). Stated differently, TIC, is the rate of interest, compounded semiannually, required to discount the payments of principal and interest paid over the life of the issue to the original purchase price.
Note: Actual figures may vary somewhat from those shown in the tables above due to rounding.

March 23, 2007

 

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