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

#aThread

On Friday 29th May, 2020, 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 30th 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 2020.

In this thread, I will explain the meaning of an early bond redemption, the mechanism that 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. issuer promises 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.

WHAT 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. Any expected future interest from the date of the call to the initially agreed maturity date would no longer be payable since the bond no longer exists. Investors forfeit this future interest since they have now received their investment.

In the case of the UBA bond, any interest that would have been earned by investors at the 16.45% coupon rate between 1st July, 2020, and 31st 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 would...

... 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 a company may choose to exercise 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...

...apparently there’s a limit to how long you can make a thread...

Read the rest of this piece on my blog:

https://www.nosaugiagbe.com/2020/05/uba-issues-notice-of-early-redemption.html?m=1

@eboayodeji @FinPlanKaluAja1 @FemiJemilusi