Last week, Potomac Electric Power Co. announced plans to redeem $50 million in 10-year, 14.5 percent bonds that it issued in 1981. To do that, it will use money it raised with new notes paying 9.25 to 11.25 percent. The saving for Pepco: $1.5 million in interest payments over four years.
Two weeks earlier, Manor Care Inc. said it would redeem $27.3 million in subordinated debentures at a savings of $1.1 million annually in interest payments over the next 16 years.
American corporations, just like homeowners and others who took on long-term debt in the early 1980s, are rushing to take advantage of falling interest rates.
Corporate refinancings are running at a record rate -- three times the pace of the same period last year -- and Wall Street experts figure that new debt placed this year will save companies about $4 billion in interest payments over the next 10 years.
But while the rapid decline of interest rates in recent months from their peak in 1981 has provided a stimulus for the economy through lower financing costs for business, and while lower inflation has meant more spendable income for consumers, there is a downside. Someone must pay the price for reduced interest rates.
Investors who snapped up high-coupon bonds with the intention of locking in rates for years to come now are facing up to the reality of vanishing investments: a loss of anticipated income and, in some cases, of capital.
The $4 billion saved by corporations will be lost to lenders. And earnings to holders of mortgage-backed securities could fall by as much as $39 billion over the next 30 years as a result of refinancings and lower interest rates, according to some estimates.
Salomon Brothers Inc., a New York investment banking firm, has dubbed 1986 the Year of the Call. A study by Andrew J. Kalotay and Stanley Kogelman predicts that an "unprecedented" number of corporate bonds will be called or refunded.
A callable bond is one that may be redeemed by the issuer prior to maturity. The bond usually is redeemed at a premium price over par after a certain date. The premium decreases over the years until maturity when bonds are paid off at par.
More than two-thirds of all bonds issued have call features. Callable issues generally carry a higher interest rate than noncallable ones. Most utility bonds, for example, are callable after five years. That accounts for the large number of utility bonds issued in 1981 that are being redeemed now.
The Salomon Brothers analysis of investment-grade bonds (those with a Standard & Poor's rating of at least BBB-) indicates that about 218 utility issues with a face value of $19 billion will be redeemed this year. That represents the majority of the 330 domestic corporate issues with a face value of $28 billion that the firm expects to be refunded in 1986. In all, 6 to 7 percent of the corporate domestic bond market, which totaled $435.2 billion (7,519 issues) at the end of last year, will be redeemed, Kalotay and Kogelman predict.
In the first quarter of 1986 alone, 80 issues with a face value of $7.8 billion were called, according to Salomon Brothers. That compares with $2.4 billion during the same quarter in 1985 and $8.9 billion for all of that year.
According to the Bond Buyer, a trade publication that covers the tax-exempt-bond market, refunding of municipal bonds amounted to $5.9 billion during the first quarter compared with $4.97 billion during the same period last year. These numbers were distorted, however, by uncertainty over the tax-exempt status of the bonds. The bulk of the activity ($4 billion) came in March after the Senate Finance Committee decided that many new issues would retain their tax exemption.
The number of called bonds could increase further this year if 30-year Treasury bonds fall below their current rate, which is less than half their record high of 15.2 in 1981. Corporates hit 19 percent in 1981. If the current trend continues, Kalotay said he expects that bonds with face interest rates (known as the "coupon" rate, or coupon, for short) as low as 9.5 percent could be refunded this year.
It might be expected that so-called junk bonds, those high-yielding issues popularly used in takeovers for several years, would be called more frequently. The average junk bond was paying 12.92 percent in March, or five percentage points more than Treasuries.
Yet Larry Post, a researcher with Drexel, Burnham Lambert in Los Angeles, estimates that just $1 billion out of a total of $82 billion outstanding have been called this year. Much of that was one issue by MCI Communications Corp. Because so many junk bonds were issued in recent years, the minimum five-year call protection hasn't yet expired. Also, Post said junk-bond issuers may not be as sensitive to small shifts in interest rates as other issuers or may not want to reduce their earnings to pay the premiums.
Using the difference between the average coupon rate on called bonds and the average coupon rate on new issues, Salomon Brothers economist Nancy Kimelman calculated that, during what would have been the remaining eight to 16 years to maturity, investors will lose $84 million in interest payments from bonds issued by banks and financial institutions, $403 million from industrials and $3.3 billion from utilities, for a total of $3.8 billion.
"Industrial bond calls are more of a risk than utilities, which are more predictable," Kimelman said. Most industrials have 10-year nonrefunding protection, but that does not prevent them from being called. Although a corporation cannot borrow to refinance these bonds, it may use cash, sell assets or issue stock to pay them off. The "cash calls" of relatively new issues are what Kalotay calls a "cold shower" for the investor.
Investors, particularly institutional ones, do not like surprise calls. Thus, when the New York City Housing Development Corp. (HDC) announced that on May 1 it would redeem $174 million in bonds issued in 1982 with coupons up to 12 3/4 percent, John Nuveen & Co. filed suit to stop the redemption. And last Thursday, the Bank of New York, the trustee for unit investment trusts that hold more than $48 million of the agency's bonds, also challenged the redemption in court. HDC planned to sell the mortgage portfolio backing the bonds for a $40 million profit and pay off the bonds at par. In arguing that HDC broke its contract, trust attorneys said that the proceeds could go only to the bond holders.
Nuveen, the country's largest packager of unit investment trusts, has $12 million in HDC bonds. Besides Nuveen and the Bank of New York, those taking legal action against HDC include Van Kampen Merritt, a trust with a $13 million exposure; Municipal Investment Trust, with $20 million; and Moseley, Hallgarten, Estabrook & Weeden, also a trustee.
A unit investment trust is a closed-end mutual fund; i.e., called bonds cannot be replaced in the portfolio; thus, when all the bonds are paid off, the trust is terminated. Premature payoffs in such trusts result in lower yields for investors. Trusts that purchased high coupon bonds at a premium also stand to suffer a capital loss.
Investors in mortgage-backed securities face an even larger disappointment. Andrew S. Carron, senior vice president of the mortgage research and analysis division at Shearson Lehman Brothers Inc., estimates that lost interest payments on all such securities issued by the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac) or guaranteed by the Government National Mortgage Association (Ginnie Mae) will amount to $39 billion over 30 years.
Using a coupon-by-coupon analysis of all these securities, Carron determined that a year ago the investor could count on the investment to pay off for 11.3 years. Today, the average life span of that investment has been cut to seven years. At current interest rates, that means a loss of $2 billion in interest payments this year.
The life span of Fannies, Freddies and Ginnies, as these securities are known, will shorten even more if interest rates continue to fall and mortgage holders continue to refinance their loans. These debt securities cannot be called, and GNMA Vice President Louis Gasper says no issue ever has been paid off entirely before maturity. Nevertheless, prepayment of mortgage loans shrinks the size of the portfolio so the effect is somewhat the same as a call in reducing the income that was expected to flow over a number of years.
If an investor bought a 15-percent-coupon Ginnie Mae at par when issued, he or she would continue to receive 15 percent on the outstanding balance for the 15-year or 30-year life of the security. However, 15 percent Ginnies now are being paid off at a rate 40 percent higher than originally expected. So a 15 percent Ginnie Mae purchased today at the market price of 114 can be expected to liquidate itself within two years.
Consequently, many investors will get a much smaller return on their money than they might have anticipated. In their advertisements, sellers of Ginnie Maes commonly try to attract investors by listing either current yield (the coupon divided by the price) or the widely used "benchmark yield." This yield is calculated assuming no mortgages in a portfolio will be paid off until the 12th year. A more realistic measure of the investment is the bond equivalent yield, not generally available to the average investor.
The difference can be startling. For example, the current annual yield on a 15 percent Ginnie Mae, based on this week's market price, is 13.16 percent. The benchmark 12-year average life yield is 12.61. But the effective yield over the next two years will be just 6.78 percent annually.
Investors who expected higher yields over more time may feel disappointed. Gary Peters, a senior vice president of the Exchange National Bank of Chicago and head of its Ginnie Mae division, said unsophisticated investors were not the only ones taken in by the high yields on Ginnie Maes. He noted that some mutual funds, which bought them at a premium, have taken capital losses and have reduced their dividends to shareholders. Several even have sent them letters explaining why they are earning less when declining interest rates would seem to indicate they should be profiting.
However, Joseph Hu, senior vice president for mortgage research at E. F. Hutton & Co., offers some consolation: "If one does not look at Ginnie Maes as a 10-year investment, but as a two-year investment, and if one considers market rates on comparable securities, there is no loss." He points out that the 6.78 percent effective yield is still 34 basis points (one-third of one percentage point) above what an investor would earn on a two-year Treasury bond. For Ginnie Maes with 11 or 12 percent coupons, the advantage over comparable Treasuries is almost three percentage points.