When Archer-Daniels-Midland, an Illinois agricultural products manufacturer, announced earlier this year that it would reduce its debt costs by redeeming $125 million in debentures 28 years before maturity, it ran into opposition from several of the major bondholders who held ADM's 30-year notes paying a coupon rate of 16 percent.
The investment banking firm of Morgan Stanley, which had purchased $15.5 million of the bonds, sued ADM along with Wells Fargo and General Reassurance Corp., charging that ADM had broken its contract with bondholders by using the proceeds from a lower cost debt offering to refund the l6 percent bonds.
ADM claimed it had refunded the debt with the proceeds of a stock issue and a federal judge ruled in ADM's favor.
On August 1 ADM redeemed the debentures, which were issued in May 1981, at a price of 119.96 per $100, well below the open market price before the redemption was announced.
According to court papers, Morgan Stanley bought $15.5 million at 125.5 and another $500,000 at 120.
Spokesmen for the company declined to reveal its precise losses.
The ADM case is unusual, observed Dick Swingle, a vice president of T. Rowe Price in Baltimore. He could recall only two similar cases in the past decade.
However, the situation is not. After several years of record interest rates followed by a steep decline, refinancing initiatives are reported to be at a high level.
It is only natural for borrowers, whether corporations or homeowners, to try to reduce their interest rate burdens by refinancing. Yet redemptions, which cut off the predicted flow of funds, can have serious consequences for investors if they cannot reinvest their money at a comparable rate.
Almost all bonds can be called or redeemed prior to maturity. However, investors also usually have contractual protection against refunds on corporate bonds for a five year period.
Last May the California Public Service Commission requested all major telephone and electric utilities in that state to reduce their cost of debt as much as possible through tender offers or open market purchases. Furthermore, it sent letters the following month to other state regulatory commissions reporting its actions and recommending they do the same.
In the tax exempt sector, there has already been a high degree of redemption of housing bonds. According to Tom Buckmeyer, a municipal bond analyst with Smith Barney in New York, the firm is projecting that up to 35 percent of the $4.73 billion in outstanding state housing authority bonds and 35 percent of the local housing bonds will be redeemed before their 30 year maturity. A large number of these bonds, which carry an average coupon rate of 13.5 percent, were issued as a cheaper alternative to FHA financing, when that rate soared to around 17 percent. New single family mortgage revenue bonds now have a coupon rate of about 10.25 percent.
Tom White of the Council of State Housing Agencies reports that housing authorities have not been affected by the refinancing in their ability to raise new funds without paying a premium. Buckmeyer says those investors hurt the most are those who bought the high interest bonds at a premium in the secondary market in the expectation they would receive the payments over many years and that the bonds would increase in value. But as soon as the redemptions began, the market price declined.
In the taxable bond market, the market value of investment grade bonds outstanding with a coupon of 14 percent or more amounts to $13 billion, according estimates by Daniel E. Kornstein, a vice president of Merrill Lynch. The par value of these industrial, utility and financing bonds is $11.75 billion. So if interest rates continue to decline and all the bonds are redeemed at par, investors could lost $1.25 billion, a small but significant fragment of the total value of corporate bonds.