The devil is in the details

As interest rates remain low, many issuers of debt (e.g. bonds, corporate notes, etc.) will look for possible ways of reducing their interest expenses. They may do this by executing call options and reissuing debt at lower rates. These lower rates will reflect the current market levels for the associated risk. Rather than continuing to pay high interest payments, it is to their benefit to pay off these debts and save money by issuing new instruments at the lower rates.

This makes it important for an investor to know and understand the details of these types of instruments before investing. Often, we merely look at the coupon/interest rate and the company rating. However, it is even more important to look at the “fine print”. As the old maxim says, “The devil is in the details”. The possibility of a debt instrument being called is sometimes not as obvious in the description of an instrument as we would like it to be.

Given the low interest rate climate, in recent times we have seen several companies execute call options on these debt instruments.

What is a call option?

A call option is a contract giving the owner of the option the right, but not the obligation, to buy back a security at a specified price and a specified time. Please note that it is not an obligation. The option owner will only execute if it is in their best interest. In the case of a bond issuer, this means that the bond issuer could buy back their bonds, if is in their best interest at the time the call option is executable.

 In recent times issuers with instruments paying high interest rates are now able to acquire cheaper funding. To do this, they will execute their call option to repurchase their high interest rate debt, and issue new instruments at lower rates. This will allow them to save money on interest expenses. If market interest rates were higher than the issuer’s current cost of capital, then they would not execute the option and allow it to expire as it would not be in their best interest.

Another key feature of the call option that an investor should be aware of is the call price. The price at which the owner of the contract can repurchase the debt instrument. This call price may be at par ($100) or at a premium (over $100). This is important when making the purchase to determine any possible capital gain or loss if the bond is called.

Types of call options

Also of note is that there are different types of call options. There is an American call option, a European call option and a Bermudan call option. Each having distinctive features and can affect the investor differently.

An American option can be executed at a specified price at any time between the purchase date and the date of expiration of the option. Once conditions are favourable the issuer may execute during this period. If not, they will let the option expire at the end of the period.

A European call option is only executable at the date of expiration. On the pre-set date if conditions are favourable the issuer will execute. If not executed on the specified date, then the option will expire.

A Bermudan call option is a hybrid option which has some features of both the American and European call options. It can be executed at several specified dates before it expires. The call prices at the various dates may also vary and should be taken into consideration when investing.

Always get the details and understand the investment before making a commitment. Speak with a licensed financial advisor who can help you to understand the fine print and guide your decision. The details can affect your profitability and should be considered when investing.

Dwayne Neil, MBA, is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor.

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