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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.
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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.
|
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3. |
In the above example, the True Interest Cost is .07% higher
for the callable premium priced bonds.
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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.
|
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2. |
In the above example, the increase in rates from 4.65% to 4.95%
increases the True Interest Cost by .14%.
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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%.
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Recommendations for Issuers
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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.
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2. |
Working with your independent financial advisor, issuers should
work to minimize premiums on callable bonds without impairing bond
marketability.
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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.
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_________
* 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 slightly from
those shown in the tables above due to rounding.
March 23, 2007
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