This was a week to forget for institutional fixed income investors in Canada. For a change, gas & oil exposure concerns relinquished centre stage in the circus to extension risk on junior subordinated hybrid debt securities.
Great-West Life (GWO) mid-month declined to exercise their call option on their US$300mm 40NC10 fixed-to-floating hybrid security (GWOCN 7.153% 05/16/46 cusip 39136WAA2) which has sent shock waves through the C$45bln domestic market for comparable fixed/float hybrid securities. GWO, it should be noted, is well within their rights as per the bond indenture for the said security, the call option right was theirs solely. Market practice to date led institutional investors to expect Great-West to call the security at the nearest call date, the 10 year anniversary 05/16/2016 in this case, the point at which the fixed coupon ceases and a floating rate (based on the 3 month US$ Libor rate + a spread of 253.8bp) comes into effect should the securities not be called. Top holders of the bonds include RBC Global Asset Mgmt (18%), Fidelity (15%), USAA (12%) and Sentry Investments (11%).
The call feature is not identical for all debt securities. The call on the subject Great-West Life issue is a “European” style, meaning the issuer has a 1-time option to call the security (at $100, par in this case), on 05/16/16, with the appropriate notice to holders.
At the time of issuance in 2006 (Lehman was the book runner, not yesterday), Moody’s rated the issue Baa2 based on the 40 year (final) term and covenant that Great-West would replace at the maturity date (or call date, if so exercised) with an instrument with equal or better “equity characteristics”. Moody’s places the issue in basket D (75% equity / 25% debt) and it should be noted that the ranking is equivalent to Great-West preferred stock in liquidation, offering a loss absorbtion cushion to securities of higher priority. The bond have held the Baa2 through the non-call period and the underlying bond traded at or above par through October 2015. The latest announcement (call not exercised) saw the bond break $90 (down 5 5/8ths in price terms).
As an aside, if the call option were “American” style, Great-West Life could exercise any time on or after 05/16/16 (with specified notice). The other variant is “Bermudan” (between the other two),where the call can be exercised at any coupon payment date (semi-annual in this case) on or after 05/16/16.
What are the risk?
To investors: The main risk for investors, especially in the high grade sector, is extension risk. If the securities are not called they may remain outstanding for a considerable time (30 years in this case), affecting returns and causing a downward realignment in pricing due to the much longer maturity profile.
To issuers: Market access and the clearing level for future issues can be affected when large institutional investors feel slighted. If this were about a relatively small US$300mm bond issue there would be little impact, but the underlying market for like securities is very large ($45bln +) and significant downtrade in the secondary market pricing of other securities has been evident. The C$1bln Great-West Life 5.691% 06/21/67 also traded down hard on the week as the delta of the 06/21/17 call fell on this new information. The bonds fell $8+ on the week to settle approx. $95.50.
Value may emerge from the carnage, but significant homework is warranted. Great-West prefs are good as a comp, but are not very liquid compared to other names I have profiled in the pref space.
Black-Scholes does not capture all the pricing idiosyncrasies of options pricing when the needs and wants of PMs (buyers) and Treasurers (issuers) do not fully line up. Hybrid securities are inherently complex instruments. JCG
Note: All publicly available information.
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