Important Bond Features

On 07/26/2010, in Fixed Income, by Jordan Wilson

To date we have mainly considered bond examples using plain vanilla debt instruments.

That is, debt with a par value in the investor’s domestic currency, a fixed term to maturity, and a consistent coupon rate. But bonds may also vary from this simple structure. There may be features incorporated into the debt terms that affect the issue.

These features may significantly impact the debt issue and returns to investors.

Bond features are extremely important to bear in mind when investing in bonds.

Features may affect any or all components of the issue, including: issue price, currency paid, yield on the debt, collateral, and term to maturity.

Features may be be favourable to the issuer, so you need to monitor the terms of the bond to ensure you know what you are buying.

Features may also be favourable to the investor.

Known as “sweeteners”, these features attempt to make the issue more attractive to the investor. The issuer hopes that a sweetener will induce investors to purchase the debt due to the feature and be happy receiving a lower yield in return.

Callable or Redeemable Bonds

The issuer has the option to force bond holders to redeem their bonds at a specified price at, or after, a predetermined date or dates.

This feature benefits the issuer, not the investor.

For example, you own a $1000 30 year US Government bond with a 10% coupon issued at par. As it was issued at par, it is fair to assume that the market’s general long term interest rate is also 10% (US Government bonds are considered extremely safe, so the risk premium should be quite small).

Let us assume the bonds are callable at $120 after 10 years. Remember that bonds are priced in bases of $100, so your $1000 would be callable at a market value of $1200.

As general interest rates fall, the price of your bond will rise. Why?

Because the coupon rate of the bond is still 10%. If general long term interest rates fell to 7%, the yield on the long term US Government debt should also fall to reflect market rates. As the coupon does not decrease, the price of the bonds must rise so that buyers in the secondary markets only receive a 7% yield to maturity.

At the 10 year mark, general long term interest rates are at 7% and your bond has a market value of  $1320 ($132 in bond pricing terms). As the bonds are callable after year 10 at $120, the issuer will redeem the issue and you will get less than market for your bonds.

That is why callable bonds are beneficial to the issuer and not the investor.

Note that in real life the market value of the bond above would not be $1320. That is because the market price would reflect the capped value of the call provision and peak at $1200.

Retractable Bonds

This sweetener gives bond holders the option to redeem their bonds at par, at a predetermined date (or dates) before maturity. This early date is known as the retraction date.

The advantage to investors again lies in comparative interest rates.

In our example above, let us assume that the bonds are retractable and not callable. Also assume that interest rates rise to 12%. As your coupon rate is below market levels, your bond will trade at a discount to face value. In this instance, it will trade at $850.

However, by having the option to force the issuer to redeem the bonds at the $1000 par value, you will create a gain of $150 from market value.

Then you can take your return of capital and invest in a new debt security that will pay a greater coupon of 12% for your $1000.

Extendible Bonds

Another sweetener for investors.

This feature allows the bond holder to extend the maturity date of the bond to a predetermined future date, under the original terms of the issue.

This is attractive for investors when they hold debt with a coupon rate higher than the current interest rates.

For example, say your bond has a coupon rate of 10% and the current market interest rates for comparable debt is 7%. If your bond matures in 1 year, you will receive the face value and then must reinvest the principal in a new bond yielding only 7%.

This is reinvestment rate risk that we discussed previously.

But if you are able to extend the life of the bond another 5 years at the 10% coupon, that is a great benefit to you.

Variable Rate Bonds

We looked at these in a previous post. In fact, all the bonds in that post have unique features.

It is usually a benefit to debt holders to possess floating interest rate bonds, but not always.

If rates fall, bond holders may see their interest income also decrease. Often, there is a minimum interest rate below which the coupon will not fall. This gives bond holders some protection if interest rates fall too far.

But if rates increase, investors will see their coupon rate adjusted upwards and allow them an increased cash flow from the bond.

Protective Provisions

Anything that reduces the risk of loss to investors is beneficial to them.

Provisions within the debt issue which protects the issue is advantageous to investors.

If an issuer agrees not to sell any capital assets (e.g. plant, equipment, real estate) valued at greater than $10 million without bond holder approval, that would be a protective provision.

Similarly, if the issuer pledges specific assets as collateral for the debt issue, that is also an example of a protective provision.

Convertible Bonds

With this sweetener, bond holders have the option to convert their bonds into a fixed number of common shares of the same company that issued the bonds for a fixed period of time.

This is considered advantageous to the investor. Why?

Normally, bond holders invest in a debt instrument of a company and receives semi-annual interest payments plus a full repayment of capital at the bond’s maturity.

But the convertible bond holder gets a bonus. Because he has the option to convert his debt into shares at a fixed price, he can also benefit from the performance of the issuer.

If the company does well, hopefully their share price will increase.

If you hold straight bonds, you do not really care how the company’s shares perform. As long as the company can service its debt, you are content. But if you own convertible debt, you can take advantage of how the company performs.

For example, you and your brother decide to invest in debt instruments of Growthco. Your brother purchases $1000 in straight 10 year bonds with a coupon of 10% issued at par. You acquire $1000 of Growthco 10 year convertible bonds with a coupon of 5%. They are convertible at any time after 5 years at $20 per share. The share price at time of issue was $10.

Over the life of the bonds, your brother receives annual interest of $100 and you receive $50. Being your brother, he enjoys reminding you that his annual income is double yours.

But in year 8, something changes. Growthco announces a cure for baldness. Their share price soars to $100 per share. You convert your $1000 face value bonds for 50 shares at $20 per share and sell the shares on the open market. You net $5000 on the transaction.

Your brother meanwhile, cannot participate in the company’s share growth. Instead, at the end of year 10, he is simply repaid his original principal of $1000.

Being a good person, you do not laugh at your brother’s result. Okay, yes you do!

Exchangeable Bonds

Very similar to convertible bonds, so do not confuse the two features.

With a convertible bond, the holder may convert the debt into shares of the same company.

With an exchangeable, the investor may convert the debt into a fixed number of common shares of a related company to the issuer. The related company is usually the parent company or a subsidiary of the bond issuer.

Warrants Attached

Warrants give the bond holder the right to purchase a certain number of common shares at a specified price for a specified time period.

In some ways, warrants are similar to convertible or exchangeable bonds as they allow the investor to participate in the performance of the issuer or related company.

The difference is that the warrants are treated as a separate asset from the bonds. As such, they can be separated from the bonds and traded on the secondary market by the holder.

We will look at warrants again in the future.

Relevance to Investing

There is no such thing as a free lunch. Or so the saying goes.

This is equally true in the investing world.

When considering investing in debt instruments, pay close attention to the features.

Note that a single debt instrument may have multiple features.

You may have noticed above, features are really just “embedded options” in a debt issue.

And like all options, the one holding the option must pay for it.

If an issuer includes bond provisions that are advantageous to it, you need to extract a greater return for your money than if the feature was not present. This may be through higher coupon rates, a discounted issue price that enhances the yield to maturity, or even adding other features that sweeten the issue and offset any negative provisions.

If the issuer includes sweeteners to entice investors, that is nice. But you also need to be wary.

The option that the bond holder receives will come at a price. If you invest in bonds with sweeteners, you must learn to value the embedded option and decide if the cost is worth it.

There are formulas to value embedded options. However, that is outside the scope of our discussions. If you enter the world of finance, you will learn more than you want to ever know.

For now, be aware that sweeteners may be used to make an unappealing bond issue attractive.

For example, the issuer may be offering a lower than market coupon rate on the debt to minimize the company’s interest payments. Maybe the credit rating of the issuer is too low to attract lenders on the issue’s own merit. Or perhaps the premium required for a convertible bond is too high for the potential payoff.

There are many reasons why sweeteners are offered to enhance a bond issue’s marketability.

I would suggest that you only consider sweeteners that are of value to you.

In our brother example above, you invested in the convertible debt. However, you should only have done so if you had analyzed the company and believed that a direct investment in the common shares was prudent. If, at the time you acquired the bonds, you did not see Growthco stock as a good long-term investment, you should not have sacrificed the extra interest income for the option of buying the shares.

Remember with sweeteners, that the features you receive come at a price.

As you gain both technical skill and practical experience investing, you will be in better position to assess the impact of features in an individual debt instrument.

2 Responses to “Important Bond Features”

  1. Merely needed to mention I truly admire your work on this blog and the quality posts you make. These type of blog post are usually what keeps me going through the day time. I uncovered this post after a great companion of my own recommended it to me. I do some blogging myself and I am always thankful to see others contributing good quality data towards online community. I am going to certainly be following and have saved your webblog to my twitter account for others to see.

  2. I was just studying this page it’s very well written, My organization is exploring on the net trying to find out the correct way to start this blog site thing and your website is almost certainly quite impressive.

© 2009-2018 Personal Wealth Management All Rights Reserved -- Copyright notice by Blog Copyright