U.S. companies including hotel chain Hilton Worldwide Holdings Inc. are so anxious to lock in low borrowing costs now, before inflation fears push yields even higher or close the market altogether, that they’re paying millions of dollars in penalties to refinance debt early.
The corporations, which also include car renter Avis Budget Group Inc. and financial index company MSCI Inc., are selling new bonds and using the money they raise to buy back existing notes. But those repurchases come at a cost: high fees they have to pony up to buy back securities early. Usually those fees, known as call premiums, would be lower or even zero if the company waited anywhere from a few months to a year.
More of these deals may be coming. There’s at least another $70 billion of outstanding bonds that would make sense to refinance now instead of waiting for the next date at which buybacks become cheaper, according to a Bloomberg Intelligence analysis. Many companies are betting they’ll come out ahead if they just pay the fees now, because if they wait too long, they’ll end up having to pay much higher interest costs, or may find they can’t even sell notes.
Take Avis, for example. In February it sold $600 million of bonds to pay off notes it sold around the nadir of the pandemic in May 2020. The securities it refinanced would have matured in 2025, and buying them back now cost about $60 million more than the car renter would pay to call them next year. But it’s also cutting $20 million of interest expense a year with the new debt compared with its existing notes, a savings that could decline if it waited until 2022.
“If you had confidence the market would stay open and yields would stay low, it would be better to wait,” said Noel Hebert, director of credit research at Bloomberg Intelligence.
Surging Yields
Bond yields have jumped this year as investors have grown more concerned about inflation after the U.S. government injects $1.9 trillion of stimulus into the economy. The 10-year U.S. Treasury yield had surged more than 0.8 percentage point in 2021 through Friday to around 1.72%.
Average junk bond yields had risen 0.37 percentage point through Friday, but the notes could get hit harder if markets become more panicky, in part because prices on the securities are relatively sensitive to changes in yields now. If a selloff is extreme enough, the market for new issuance could effectively close, as it did in 2013 when yields jumped after the Federal Reserve talked about cutting back on quantitative easing, a period known as the taper tantrum.
Fear that higher borrowing costs are coming has helped boost high-yield note issuance, which through Friday was up more than 80% from this time last year. The first quarter is already the second-highest for junk-bond sales on record, and this is set to be the busiest March in history.
Rising yields are forcing companies to make complicated calculations. They can reduce their interest expense by refinancing debt that is close to maturing, because yields are close to all-time lows. That savings alone may not be enough to cover the penalties associated with calling debt early. But waiting longer could reduce the savings significantly, or force the corporation to refinance when markets are closed, leaving a borrower worse off than if it had just refinanced now.
“A lot of companies are saying, ‘I’m better off issuing now since I’m going to pay that rate for the next eight or 10 years, even if it means paying penalties for calling bonds early,’” said Alexandra Barth, who co-heads the group that sells high-yield bonds and leveraged loans at Deutsche Bank AG in New York.
More Coming
The market seems to be bracing for more companies to buy back their debt through calls. About 60% of the bonds in the high-yield market are trading above their call price, while the typical number is 40%. Bonds trading above their call price are usually a sign that money managers expect more refinancing, said Robert Spano, portfolio manager at PGIM Fixed Income.
“More investors are seeing that companies are going to refinance before their call date,” Spano said.
And corporations are definitely refinancing. Take MSCI, a provider of financial market indexes and data. It sold $500 million of notes earlier this month to refinance bonds due in 2026. Those securities aren’t callable until August, when they can be bought back at 102.375 cents on the dollar, and aren’t callable at face value until 2024.
Or Hilton Worldwide, which sold $1.5 billion of bonds in January, and used the proceeds to buy back notes due 2026. The early redemption resulted in somewhere around $55 million of call premiums and other fees.
If the hotel owner had waited until May, it could have cut its penalties to closer to $40 million. But with the lower interest it’s paying on its new securities, the company is saving about $22.5 million a year. A spokesperson for Hilton said since the start of 2020 the company has lowered its weighted average interest rate to 3.5% from 4.36% and raised $4.4 billion of debt, of which $3.4 billion was used for refinancing.
The Math
If companies can sell a bond at a yield about 10% less than the current average funding cost for that credit rating, there could be even more than $70 billion of refinanceable debt-- the figure might be closer to $105 billion, according to Bloomberg Intelligence. The BI analysis looks at the net present value of funding costs at the average index coupon, the remaining life of the refinanced obligation and the payment of the make-whole premium to call.
For most of the last six months, as Treasury yields have risen, risk premiums on junk bonds narrowed as well. That helped keep yields relatively low on speculative-grade notes, which meant that for many companies, refinancing still made sense.
But junk bond prices have become more sensitive to inflation fears than in the past, in part because coupons on bonds are so low. If yields were to rise by another 0.5 to 1 percentage point, the calculation could change for companies and refinancings would not be as attractive, said Jonathan Sharkey, portfolio manager at Amundi Pioneer.
“This time is going to be a little different. That’s just the way the math works,” Sharkey said.
