UBA issues a notice of early redemption to investors (bondholders) – a look at callable bonds

On Friday 29^th May, 2020, one of Africa’s biggest banks, United Bank for Africa Plc (UBA), issued a notice of early redemption to investors, exercising the call option attached to the bond at the issue date, thereby informing investors that the bond will be redeemed on 30^th June, 2020.

The bond has a principal amount of N30.5 billion (around $84 million, at an exchange rate of N365 to a dollar), coupon or interest rate of 16.45%, and was issued for a 7-year term with a maturity date of December 2021.

In this piece, I will explain the meaning of an early bond redemption, the mechanism which makes it possible for a bond issuer to redeem the bonds before the initially agreed redemption date as well as the implication for investors.

What is a Bond?

A bond is a fixed income instrument representing a loan made by an investor to a borrower (issuer), with the issuer promising, in writing, to make an agreed stream of periodic coupon (interest) payments, as well as to return the principal amount (initial investment) to the investor on specific dates in the future.

The issuer could be a company or government and the instrument or contract given to the investor in exchange of the money at the start of the contract is the bond or fixed income security.

Bonds are classified as fixed income securities because the amount of cash flows (interest rate and principal repayment) and timing of cash flows (interest payment date and redemption / maturity date) are known with relative certainty at the start of the contract, irrespective of the performance or economic circumstances of the borrower / issuer.

I explained the difference between fixed income securities and equity securities in this episode of my Podcast.

What then does an early redemption mean in relation to a Bond?

You may be wondering: “if the timing and amount of cash flows associated with “fixed income” securities are fixed, how then can a company like UBA decide to pay back investors 18 months before the agreed date?”. To answer this answer, I would need to explain “call options”.

There are different types of bonds but the one of interest to us today is the “callable bond”. A callable bond is a bond with a call option embedded within it. A call option gives the issuer of the bond the right or choice to “call” the bond.

Calling the bond simply means that the issuer chooses to return / pay back the money borrowed from investors at an earlier date than the initially agreed maturity or redemption date, thus cancelling the bond.

The call option is a right which the issuer can choose to exercise or not to exercise, but it is in no way an obligation. If the issuer chooses not to exercise the option, the initially agreed terms and conditions of the bond continue to be in force.

What does a call mean for investors?

When a borrower exercises a call option, the payment made to the investor typically includes the principal (initial amount borrowed) plus any interest that had accrued from the date of the last interest payment to the date of the call.

The call effectively cancels the bond and any expected future interest payment from the date of the call to the initially agreed maturity / redemption date would no longer be payable since the bond no longer exists. Investors forfeit this future interest since they have now received their initial investment.

In the case of the UBA bond, any interest that would have been earned by investors at the 16.45% coupon rate between 1^st July, 2020, and 31^st December, 2021, will be forfeited. The principal amount received by the investors can then be reinvested in any other security of their choice, at the prevailing market conditions.

What’s in it for the borrower / issuer?

A call option is usually embedded in a bond to protect the issuer from interest rate risk. In the last episode of my Podcast, I talked about the relationship between risk and returns and explained the different components of risk for which investors would require compensation, in building up their total expected return for that security.

The risk components (for fixed income securities) discussed in that episode include:

• real risk-free rate (compensation for forgoing current consumption to a future single-period date);
• compensation for expected inflation rate;
• maturity premium (compensation for extended duration and exposure to interest rate risk);
• liquidity premium (compensation for potential loss of value due to illiquidity);
• credit spread (compensation for the possibility of default and the extent of loss in the event of a default);

 

I explained that when interest rates go up, the value of existing bonds typically go down because investors already locked in their capital at lower rates than the current market interest rates. In the same vein, when interest rates go down, the value of existing bonds go up because investors have already locked in their capital at interest rates that are higher than the prevailing rates in the market.

In a low interest rate environment, a company can typically borrow money at lower interest rates. Accordingly, when interest rates go down, companies who had issued bonds with call options embedded in them, have the opportunity to exercise these call options, pay back existing bonds (which have interest rates that are now higher than prevailing market rates).

Many companies with callable bonds typically issue new bonds at the low interest rates to pay off the called bonds.

Another reason or situation in which a company may choose to exercise the call option on a callable bond is when it has a surplus amount of cash which it does not want to pay out as dividends (in order not to increase investors’ expectations for the future) and when the prevailing market environment does not offer investment opportunities with expected returns that are greater than the coupon payment on its bonds. i.e., rather than invest cash in projects or assets that would earn 10% returns, why not pay back what we owe, for which we currently pay 16.45%?

Why would any investor in their right senses agree to invest in a callable Bond?

One half of the answer to this question lies in the relationship between risk and returns so I will answer this in two parts:

• The risk associated with interest rate risk is often compensated by one of the risk-premium components mentioned above – maturity premium. Investors in the UBA bond would typically have demanded a premium for exposing their investments to the risk that the interest rate environment would have changed by the end of the seven-year tenure, beyond their initial expectation at the point of making the investment. The impact of changes in interest rates was discussed above.
• The second reason investors typically invest in callable bonds is that in addition to the normal maturity premium for interest rate risk, an additional premium (call premium) is often added to compensate investors for the risk that the bond would be called before maturity. Hence, instead of 16.45%, a similar bond issued by UBA with the same characteristics, including maturity, may have attracted a coupon rate of 10% to 14% (these rates are given for illustration only).

As an investor it is important to understand the terms and conditions of every investment product you invest in. The fact that the UBA bond is a callable bond would have been stated clearly in the prospectus. However, it is not unusual for investors to, from time to time, miss out on certain important details.