Corporate bonds are a significant source of funding for US firms. In fact, between 2000 and 2022, US firms issued almost six times more in non-convertible bonds than they did in equity. A common feature in these bonds allows issuers to repurchase them before their due date at a set price – this is known as a fixed-price call. But why would an issuer want to do this? Often, it’s to capitalize on lower borrowing costs. Finance textbooks typically advance that firms retire their debts early to benefit from falling borrowing rates, allowing them to replace old, costly debts with newer, cheaper ones.
However, the decision to call a bond is not always straightforward. One aspect often overlooked is the effect of such calls on the firm’s relationship with its bondholders. When a bond is retired via a fixed-price call, the firm forces existing bondholders to sell the bond at a below-market value, effectively transferring value from bondholders to shareholders. Simultaneously, firms often refinance by issuing new bonds after a call. But will the previous bondholders readily invest in these new bonds despite having just experienced a negative wealth transfer? Or will they refrain from investing, feeling slighted by having to sell their old bonds at less than market value?
For instance, consider Calpine, an electric utility firm. In 2012, the firm abandoned its plans to call part of their bonds and replace them with cheaper ones, fearing it would upset their bondholders. Even though they would have saved $12 million annually in interest, they believed preserving the relationship with bondholders was more crucial. As one analyst noted at the time, calling the bond “would have ruined years and years of goodwill built up with bondholders.”
Our study delves into the implications of fixed-price calls on firms and their bondholder relations. Using data from eMAXX and US corporate bond data from Mergent FISD over 20 years, our findings reveal that existing bondholders are significantly less likely to participate in the firm’s subsequent bond issuances after a fixed-price call. On average, participation rates of existing bondholders drop by about 18%. This drop in participation is economically relevant for issuers because existing bondholders generally have the highest participation rates in a firm’s bond issuances. We control for any natural churn in bondholder participation rates that occur whenever the firm retires a bond by means that do not hurt existing bondholders. In other words, we provide evidence that existing bondholders are less likely to participate when retiring the bond hurts them.
The departure of some bondholders may not be a significant concern for issuers if the bondholders that leave are easily replaceable. However, our research reveals that the decline in participation rates is more pronounced for funds belonging to large fund families. Moreover, we show that those bondholders are more loyal and take larger positions in bonds. This implies that fixed-price calls do not alienate all bondholders equally but instead lead to the departure of the firm’s most valuable bondholders.
In practice, replacing these large bondholders after their departure poses a challenge for firms. This subsequently leads to the new bonds being held by smaller bondholders. In alignment with existing literature on the topic, our findings indicate that the absence of large bondholders leads newly issued bonds to exhibit more volatile returns, potentially hurting the issuer’s ability to raise financing on the bond market.
Our findings raise an intriguing question: If fixed-price calls have such detrimental effects on the firms’ bondholder base, do firms anticipate these consequences and adjust their call decisions accordingly? The answer is yes. We focus on the decision to delay the call, meaning to call later than what would be optimal from the firm’s perspective. The more firms delay, the smaller the call’s impact on each bondholder, suggesting that firms could strategically delay calls to retain valuable bondholders. Consistent with this idea, we find that firms are more likely to delay calls when they have more valuable bondholders in their bondholder base.
Interestingly, our results echo findings in the IPO underpricing literature. Just as firms may underprice their IPOs to ensure goodwill with investors for future offerings, bond-issuing firms seem to delay calls to avoid upsetting valuable bondholders. By delaying calls, firms willingly forgo about $10.4 million (or 1.2% of total equity) per year and per bond, suggesting that firms value strong relationships with their bondholders.
The refusal of large bondholders to participate in new bond issuances after a fixed-price call suggests that large bondholders have market power vis-à-vis bond issuers. If not, why would such bondholders abstain from participating in new bond issuances, especially if those new bonds are priced fairly? This question bears weight because the option for firms to exercise such a fixed-price call did not come for free in the first place: existing bondholders were compensated for granting the firm this option at issuances. Hence, they have no reason to “blame” the firm for exercising the option when the option is in the money. However, the difficulty of replacing large existing bondholders and the resulting negative effect on newly issued bonds appears to confer significant market power to large bondholders.
Since firms and bondholders interact repeatedly, firms may be able to build a reputation for delaying calls to attract and retain valuable bondholders. In accordance with this hypothesis, we find that firms that have previously delayed calls appear to benefit from reduced yields on newly issued bonds, as investors anticipate and appreciate the firm’s bondholder-friendly behavior.
In conclusion, while the ability to call bonds provides firms financial flexibility, it also leads to intricate relationship dynamics with bondholders. Our research is among the first to shed light on this delicate balance, offering new insights into firm and bondholder relationships within the framework of corporate call policies.
Paul Beaumont is an Assistant Professor of Finance at McGill University, Desautels Faculty of Management.
David Schumacher is an Associate Professor of Finance at McGill University, Desautels Faculty of Management.
Gregory Weitzner is an Assistant Professor of Finance at McGill University, Desautels Faculty of Management.
This post was adapted from their paper, “Call Me Maybe? Bondholder Relationships and Corporate Call Policy,” available on SSRN.