Call Schedules and the Hidden Cap on High Yield

Here is a bond that cannot go up much. The company behind it is improving. Its cash flow is growing, its debt is shrinking against what it earns, and the market has noticed. Yet the bond sits a little above par and barely moves, while the shares of the same company climb. Nothing is wrong with the bond. It is behaving exactly as its documents say it will. Somewhere in the indenture there is a call schedule, and the call schedule has put a ceiling over the price.

Most high yield bonds can be redeemed early by the issuer. For an initial stretch, the non call period, the issuer usually cannot redeem the bonds except by paying a make whole amount, a price built to hand the holder the value of the coupons being taken away, which makes an early call expensive. After that the bond becomes callable at a stated price, a premium over par, and the premium steps down over the following years until the bond can be called at par. That ladder of dates and prices is the call schedule. It reads like a table of dull terms. It is really a statement of what the issuer can take back from the holder, and when.

The mechanism runs on the issuer’s self interest. A company calls a bond when it can replace it with cheaper debt. That happens when rates fall, or when the company’s own credit improves enough that lenders will charge it less. Either way, the call arrives in exactly the circumstances in which the bond would otherwise be worth more. The holder receives the call price, loses a coupon it was glad to collect, and has to reinvest at the very moment a comparable bond has become hardest to find. Good news for the issuer turns into capped news for the bondholder.

The market knows this, so the price of a callable bond stops rising as it nears the call price. Buyers will not pay much above a level at which the bond can be taken from them. That is the hidden cap. Nobody writes it down as a cap. It emerges from the combination of a call price and an issuer who will use it. The nearer the next call date, and the smaller the premium due on that date, the harder the ceiling presses.

This is where price and yield start to mislead. Every quoted yield assumes something about when the bond ends. Yield to maturity assumes it lives to its final date, which is generous for a bond trading above its call price, because the issuer has every reason to call. Yield to call assumes redemption at the next call date. The honest measure is yield to worst, the least of the yields across every possible call date and the maturity, because the issuer controls the choice and will make it against the holder. A screen that ranks bonds by yield to maturity will place a callable bond above its call price higher than it deserves.

Price misleads more quietly. Two bonds from one issuer, with the same coupon, the same maturity and the same rank, can trade at the same price and be very different holdings if one is callable soon at a thin premium and the other is protected for years. The protected bond can rise if things go well. The callable one cannot rise much. Both fall if things go badly. The number on the screen is identical. The shape of the outcomes is not.

That shape is the real point. A holder of a callable high yield bond owns the credit risk in full and the upside only as far as the call price. If the company weakens, the bond falls with it, and nothing in the call schedule softens the fall. If the company strengthens, the issuer refinances and hands the money back at a price fixed long ago. In effect the holder has sold the issuer an option to buy the bond back, and has been paid for that option through the coupon. Whether the payment was enough is the question a yield figure on its own cannot answer.

So when I look at a high yield bond, I read the call schedule before I form a view on the price. I want to know where the bond sits against its next call price, how much protection remains, how the premium steps down, and whether there are special redemption rights. A common one lets the issuer redeem part of the issue with the proceeds of a share offering, at a set price early in the bond’s life, which can take a slice of the position away just when the equity story is working. Then I ask a plain question. If this credit goes right, what do I make? If the answer is a few coupons and a modest call premium, the bond has to be priced as a bet that the credit does not go wrong, because it cannot be much of a bet that the credit goes right.

None of this makes callable bonds poor investments. The coupon is richer than it would be without the call, and in a stable credit the holder may collect it for years. The error is to treat price and yield as a full description of the holding, when the documents have already decided how much the holder is allowed to gain.

There is a name for this shape, and it sounds more technical than it is. Negative convexity means the bond gains less when things go right than it loses when things go wrong. Rates fall or the credit improves, and the price barely climbs, because the issuer is about to take the bond back. Rates rise or the credit weakens, and the price drops the full distance, because the issuer is content to leave the bond outstanding. The holder is short the good outcome, long the bad one, and paid a coupon to accept the arrangement. In plain words, negative convexity is a coin toss where heads goes to the issuer and tails goes to you.