High yield bonds continue to be the popular investment in the capital markets this year as investors seek yield in an otherwise low interest environment. According to data from S&P Leveraged Commentary and Data, July set an all-time record with 31 high yield deals in a single month. By the end of July the market in Europe hosted €63.8 billion of paper versus €47.25 billion during the same period last year, putting 2014 firmly on track to surpass 2013’s full-year record supply of €70.1 billion from 211 deals.

With all this issuance, signs of over exuberance in the market were evident in July when investors started to push back on weakening call protection.

High yield bonds follow a relatively standardised and well established covenant structure. As a result, and due to the often short time frames involved the governing terms are not negotiated in the traditional sense. Rather, the managers of a deal will take a company’s bonds to market with a “covenant package” that they think can be marketed to investors. Periods of intense activity in the high yield bond market tend to result in a general increase in the flexibility of covenants present in the deals being sold – investors simply don’t have the time, or the coordinated bargaining power, to push back on increasingly aggressive terms.

There are certain provisions, however, that are so important to investors that resistance from the market on these terms can indicate that market fundamentals are beginning to shift towards tighter covenants. Among these is call protection – a feature of high yield bonds that investors take very seriously as the call structure will have a direct impact on an investor’s potential returns.

Investors in high yield are compensated in two ways – (i) semi-annual payments of interest by way of a “coupon”, and (ii) the prospect of market price upside if the issuing company improves its fundamentals or market dynamics move in favour of investors. An investor’s return from the latter element is significantly influenced by the call structure of the bond, the call price being the price the issuer has to pay to repurchase the bonds.

A high yield bond issuer typically cannot repurchase its bonds until the expiration of a non-call period of between one and four years (depending on the maturity of the bond) unless it is willing to pay an additional amount derived from the net present value of all interest payments through the end of the non-call period. The net present value is determined by applying a discount rate based on the yield from a government reference security plus a premium (typically 50 basis points) payable in a lump sum that most issuers consider prohibitively expensive. The aim is to give investors comfort that barring default their investment will generate the agreed rate of return for at least a minimum period of time.

Following the non-call period, bonds can be repurchased at a premium calculated based on the coupon of the bond. In the first year following the non-call period the premium will be equal to the coupon such that the repurchase price will equal par plus the coupon. This will then decline rateably each year before becoming repayable at par.

From an issuer’s point of view, any change to the typical non-call structure described above – whether through shorter non-call periods or cheaper bond repurchase options during the non-call period, called “soft calls” – will provide much desired flexibility to take advantage of a changing credit profile or market conditions.

Exceptions to the non-call period include a feature permitting the issuer to use proceeds of public equity offerings to repurchase up to 35% of the outstanding principal amount of bonds at par plus the coupon. The so-called “equity clawback”. This allows issuers to de-lever with proceeds of publicly issued equity, which is typically seen by the market as a positive credit event.

One example of a soft call which developed during the last frothy market period allows issuers to repurchase up to 10% of the outstanding principal amount of bonds per year at a premium of only three per cent redemption price. Some versions of this provision allow the 10% amount to be measured off of the original principal amount, thereby increasing the overall percentage of the issue that can be repurchased in the non-call period.

High yield bond investors will be concerned that a bond can be called at a price lower than they are willing to pay. The issuer call price will tend to limit the price in the secondary market, and reduce liquidity of the bond issue, making it harder for an investor to trade out of the bond.

Even traditional call structures can become more issuer friendly in a busy market – call periods can become shorter than normal, or equity claw provisions are adjusted to allow issuers to use proceeds from private equity offerings in addition to public equity offerings to finance a repurchase of the bonds.

Due to the direct commercial impact of more aggressive forms of non-call provisions on the investor upside, it is one of the first places to attract investor push-back in an otherwise issuer-friendly market. For example, during late July 2014 several issuers were forced to increase the length of non-call periods set when the deal was launched or drop “soft call” provisions – or in some cases both. This string of amendments during the marketing process was followed by the announcement that one issuer – which seemingly tried to save its deal by making structural changes to the call provisions described above – had to pull its offering. Over a two week period the market became more aware of this investor push back and as a result call provisions returned to more conservative levels.

Issuers have a lot to gain by attempting to adjust typical high yield call protection provisions, as flexibility around bond repurchases can make liability management much easier down the line, but the market has shown that this is one area where investors will quickly express concern if issuers push too far and for some issuers the door to the capital markets just might slam shut.