Do rising rates reduce the call risk ?

08 July 2022

This content is for professional investors only as defined by the MiFID.

In the current rising rates environment, early redemptions, or "calls", which were a significant risk factor in the past years for high-yield target maturity strategies, appear less risky today and we explain why.

CONTEXT REMINDER

Until late 2021, interest rates sharp decline in Europe and in the United States (thanks to very accommodating monetary policies) coupled with the significant credit risk premium compression have clearly accelerated High Yield and private issuers bonds early redemptions (« calls »).                       Many of these companies have benefited from this exceptional situation to optimize their balance sheet and refinance their bonds with attractive financial conditions (lower coupons and longer maturities). As a reminder, European High Yield average coupon has been divided by 2 over the last decade from 7% at the end of 2013 to 3.5% at the end of 2021 . This is especially due to the heavy interest rate fall (see graph 1).

BONDS’ EARLY REDEMPTION MECANISM (« CALLS »)

The High Yield universe is mainly (75%) made of bonds that have an early redemption option (“call”) at the issuer’s discretion. The latter will be encouraged to exercise this early redemption if the rate that it can obtain on the bond markets is lower than the coupon of its initial debt (like a household that refinances its mortgage).

By doing so, early redemptions increase (decrease):

  • When interest rates decrease (increase) 
  • And/or when credit risk premiums tighten (spread). 

The graph below  compares the average coupon on outstanding debt (blue curve) for High Yield issuers to the yield at which these same issuers can refinance on the secondary market (orange curve).

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