Understanding Optional Redemption Mechanics in Corporate Bonds

The indenture, which is the governing document for high-yield corporate bonds, contains optional redemption provisions. As the name suggests, these provisions allow the corporate issuer of the bonds to redeem some or all of the bonds, at the issuer’s option, prior to the maturity date. Bonds with optional redemption features are sometimes referred to as callable or redeemable bonds.

There is typically a no-call period. This is simply the specified number of years prior to which the bonds cannot be redeemed by the issuer at their election. No-call periods benefit investors by allowing them to lock-in the specified interest rate for a number of years. Corporate bonds often have 3-5 year no-call periods.

The no-call period comes with exceptions for certain events. One such exception is known as the make-whole redemption. This allows the issuer to redeem the notes during the no-call period if they are willing to pay an expensive “make-whole” price. The make-whole redemption price is based on the present value of future interest payments, which is in turn usually calculated based on the U.S. Treasury Rate plus 50 basis points.

Another common exception to the no-call period is known as the equity claw provision. This provision provides the issuer with the ability to use the proceeds of equity offerings to redeem a portion of the notes up to a specified percentage. The equity claw is typically capped at 30-50% of the original principal amount of the notes and is usually available for up to three years after the bond issuance date. Similar to the make-whole redemption provision, the issuer must pay a premium for redeeming notes prior to the end of the no-call period pursuant to the equity claw provision. However, the premium associated with the equity claw is typically cheaper than the premium associated with the make-whole.

When the issuer redeems or calls its bonds, it pays investors the face value of the bonds plus accrued interest up until the redemption date. Depending on the terms of the indenture and when the bonds are redeemed, the issuer may also pay investors a call premium. The call premium typically declines as it gets closer to the maturity date of the bonds, with the redemption price typically equal to par 1-2 years before the maturity date.

An example optional redemption provision may contain the following terms:

• Prior to September 30, 2028, the issuer may redeem some or all of the notes at a redemption price equal to 100% of the principal amount of the notes, plus accrued and unpaid interest, if any, to the applicable redemption date plus the applicable “make-whole” premium.

• On or after September 30, 2028, the issuer may redeem some or all of the notes at the redemption prices set forth in a table in the indenture, plus accrued and unpaid interest, if any, to the applicable redemption date.

• Additionally, prior to September 30, 2028, the issuer may redeem up to 40% of the aggregate principal amount of the notes in an amount not to exceed the net proceeds of certain equity offerings at a redemption price of 106.375%, plus accrued and unpaid interest, if any, to the applicable redemption date.