Taking thepulse of themarkets

Bond Market Commentary

Make-Whole Calls

Drew O’Neil
May 10, 2021

There are an endless number of potential features that can make any given bond different from the next. Some of these features are not common at all and some are very common. Some are well understood and others not so much. Today, I wanted to highlight one of the features that are commonly found in corporate bonds but are often not well understood: the make-whole call (MHC).

To get some basics out of the way, if a bond has a “call” feature, the issuer has the option to redeem the bond prior to its stated maturity. A traditional call will have a stated date and price where the issuer has the option to redeem the bond. For example, a bond that matures on 6/1/31 could have a call option that allows the issuer to redeem the bond on 6/1/25 at par (100) if they choose to do so. An MHC differs from a traditional call in that any potential MHC date and price are unknown at the time a bond is purchased.

There are a set of parameters for an MHC that dictate when it can be executed and at what price but ultimately, since the parameters are a moving target, the “exacts” are unknown. The date parameter typically outlines when the MHC can be executed (there could be a start and/or end date when the call period is active). The price at which an MHC takes place at is set by a formula, which is typically the greater of par (100) or a price determined by correlating a specific Treasury plus a stated spread. For example, a bond that matures on 6/1/31 might be make-whole callable until 3/1/31 at the greater of par or at a yield equivalent to a comparable Treasury plus 25 basis points. Comparable Treasury means a Treasury with a similar maturity to the bond, so in this example, likely a Treasury that matures in June of 2031. Treasury yields and prices are constantly changing, which combined with the unknown timing of an MHC execution, make both the potential price and date unknowable at the time a bond is purchased.

Corporate bonds trade at a spread over Treasuries, where the spread compensates the investor for taking on credit risk. What that means is that if the 10-year Treasury is yielding 1.50%, and a corporate bond is trading at a yield of 2.50%, then it is trading at a spread of 1.00% (or 100 basis points) over the Treasury. Prices and yields move in opposite directions, so all else being equal, a lower spread means a lower yield which means a higher price. So for this example, if the bond had a make-whole spread of 25 basis points, then the corresponding make-whole price would be higher than the current market price of the bond (as the bond is currently trading at a spread of 100 basis points). In this case, it would be rather expensive for the issuer to execute the MHC, as they would have to pay significantly over market price in order to “call-in” the bonds. As the holder of this bond, you would likely be happy to have the MHC executed, because it essentially means that the issuer is paying you higher than market price for your bond.

Let’s walk through an example to make things clearer. A bond matures on 1/15/26 with a 3.75% coupon. Its current market price is 110.5, which gives it a yield-to-maturity of 1.42%. It has an MHC feature that makes it callable at the comparable Treasury plus 15 basis points. The comparable Treasury is currently yielding 0.70%. If the issuer wanted to execute this MHC, they would take the comparable Treasury yield and add 15 basis points to it, which gives us a yield of 0.85%, and then calculate the price the corporate bond based on a yield of 0.85%. This comes to a price of 113.27. So if the issuer chooses to do so, they can “call in” these bonds at a price of 113.27. As the owner of this bond, having someone pay you 113.27 for a bond that is currently trading at 110.5 is probably going to be received positively.

Generally, this makes MHCs a fairly rare occurrence because it is relatively expensive for the issuer to execute them. As long as the bond is trading at a wider (higher) spread than the MHC spread, the issuer will have to pay above market price to execute the call. While this is generally the case, it is not a guarantee. Given the extraordinary demand for high-quality bonds in the current market, many bonds are trading at very tight spreads, especially shorter maturity bonds. This being the case, there has been an unusually high utilization of this MHC call feature by issuers recently. Just as if a bond is trading wider than its MHC spread, the corresponding call price will be above market price, if a bond is trading at a lower (tighter) spread than its MHC spread, the MHC price will be below market price. This is incentive for the issuer to utilize the feature.

So what does this mean to you as an investor? First, it does not mean that bonds with MHCs should be avoided. Many times, an MHC execution can be advantageous to the bond holder. Also, a majority of corporate bonds are issued with this feature, so avoiding this feature will effectively limit you to a very small corner of the bond market from which to find investment opportunities. It does mean that you should be aware of and educate yourself on the MHC features for a specific bond before investing. If a bond is trading tighter than its stated MHC spread (at a lower spread), then the bond could theoretically be make-whole called tomorrow at a lower price than you purchased it at today. Bonds trading tighter than their MHC spread are elevated relative to historical norms but still represent a very small portion of the corporate bond market.

As with every investment, educating yourself prior to making a decision is good practice. Remember, not all bonds have an MHC. For those that do, the MHC spread can theoretically be any number. You could be looking at two very similar bonds, while one has an MHC spread of 15 basis points and the other has an MHC spread of 50 basis points. Depending on the price of each bond, they could both be bonds you want to avoid or they both might be perfectly fine. As with many aspects of the market right now, a unique environment exists across the fixed income landscape. MHCs have been around for a long time but given current market conditions, being especially aware of how they function and their potential effects is essential when deciding on appropriate investments for your portfolio.

“You have to learn the rules of the game. And then you have to play better than anyone else.”– Albert Einstein

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