Look out for call cap on high yield upside, warns Morgan Stanley

Investors should start paying attention to the call options which are present in many high yield bonds, notes Morgan Stanley in a recent European credit strategy report (High Yield: Heed the Call). This is a feature that investors have tended to ignore, but the recent rally has brought it back into focus. The report notes that around 65% of European high yield bonds include a call option for the issuer, and that 29% of bonds are now trading within 5% of the call price.

The main impact of a call option is that the price of the bond is effectively capped because the higher the price the more likely it is to be called. This means that spread tightening does not result in the same uptick in price that a non-callable bond would experience. For example, a 200 basis point rally in spreads would translate into a seven point rally for a bullet bond, but only a 2.5 point rally for a bond such as the Liberty Global 7.75% 2014 bonds, since the would start to price to their July 2011 call date.

Other bonds that are at the cusp of pricing to their call date instead of maturity are the Cognis 95% 2014s (with a price of 101), Fresenius 5.5% 2016s (103.5) and ISS Holdings 11% 2014s (105.5). Morgan Stanley suggests switching from call to bullet bonds, or from bonds to credit default swaps.