Key Bond Features Part 2

Following up on Key Bond Features Part 1, let’s briefly review a few more common features.

The three features below allow investors to indirectly participate in the growth of the issuing company. Something that ordinary bond holders do not receive. Often, a very useful feature.

Remember that whenever investors receive a right or benefit from the feature, they pay for that right. You must assess whether the ability to profit from the underlying company’s growth potential is worth the cost.

Convertible Bonds

With this right or “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 receive semi-annual interest payments plus a full repayment of capital at the bond’s maturity.

But the convertible bond holder gets a bonus. 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 its 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 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.

Note that for the benefit of being able to convert debt to shares, you “pay” for that right via less interest income.

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 refuses to even spring for a beer.

In year 8, Growthco announces a cure for baldness. The share price soars to $100. 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

Never a Free Lunch

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.

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

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

Features Come at a Price

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.

Sweeteners Turn Bitter to Tasty

Just 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 must be added to a less than attractive offering to enhance marketability.

In our example above, the bond issuer wished to only pay 5% instead of 10%. To attract investors, the issuer needs to add potential value in other areas. In this case, through conversion rights. Other things an issuer might do include securing the debt against specific assets, making the debt senior to other issues in repayment status, adjusting coupon rates in the event of inflation, and so on. There are many options for bond issuers to try and entice investors.

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

In our brother example, 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, the features you receive come at a price. A valuable investment lesson to remember.

Key Bond Features Part 1

The most common bonds are 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.

Previously we covered adding some chocolate and/or sprinkles to the vanilla debt.

Bond Features

There may also be features incorporated into debt terms, whether the bond is plain vanilla or with chocolate sauce. Bond features are extremely important to bear in mind when investing in bonds as they can greatly impact the offering.

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. No investor would buy a bond for (say) $1250 knowing that it may be immediately called for $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, your bond has a 10% coupon rate. Current market interest rate for comparable debt is 7%. If the bond matures in one 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.

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 a protective provision.

That is all for today. We will look at a few more common fixed income features next time.

It is good to know the various terms and debt features. But another big takeaway (that I will point out over and over) is rights and obligations. If you hold a right to do something, then the counter-party is obligated to act.

A debt feature or variation may provide a right, option, or is advantageous to the investor. If so, the investor “pays” for that benefit. It may be via a price premium, reduced yield, or accepting higher risk for the yield offered.

If a debt feature is advantageous to the issuer, they should also pay a price. That may be higher yield, lower price, etc.

If you hold a right to do something, you will pay for that. If you agree to be obligated, then you should be compensated. It is important to realize when you have a right or an obligation. Also important is to assign the same “value” to the right or obligation as does the issuer.

We will see this continuously with investments.

A Few More Bond Types

While the previous post listed common bond variants, I do not think too many of you will invest directly in Certificates for Automobile Receivables or Collateral Trust Bonds. But it is good to at least know they are out there. Not to mention that you may encounter them in various bond funds.

More likely, if you do any direct or indirect fixed income investing, you will encounter the instruments below.

All of the following may be issued by governments, government agencies, and corporations.

Foreign Pay Bonds

Bonds issued by a domestic government or company, but where the interest and principal is paid in a foreign currency.

By domestic, I mean that the issuer is located in the country where the issue occurs.

When purchasing these bonds, investors must pay for them in the stated foreign currency.

For example, USA Inc. (domestic issuer) issues $100 par value 5% Euro pay (foreign currency) 10 year bonds in the USA to American investors (domestic purchasers). Investors buying the issue would pay in Euros. In turn, USA Inc. pays out its semi-annual interest payments and its repayment of principal in Euros.

Do not equate domestic with the US. The example could easily have been a German company issuing domestic bonds to German investors in US dollars, Swiss francs, Japanese yen, Canadian dollars, etc.

Or a Canadian province issuing domestic bonds to Canadian investors in US dollars, Euros, etc.

These bonds are of interest to domestic investors seeking exposure to foreign currencies. These investors expect the foreign currency to outperform their own over the life of the bond. If this occurs, they will earn the interest on the bond, plus obtain a gain on the currency when they convert interest and principal back into their domestic money.

These bonds may be of interest to bond issuers if they plan to use the funds for operations in the country using the foreign currency.

Foreign Bonds

The opposite of foreign pay bonds.

With foreign bonds, the issuer is foreign to the country where the issue takes place. Interest and principal of the bond are paid in the currency of the country where the bonds are issued.

For examples, Eurocorp, a company based in France, decides to tap the US domestic market for a debt issue. They issue $1000 par value 8% (USD pay) 30 year bonds to US investors.

The advantage to investors is that they can diversify their bond holdings globally, yet not worry about foreign currency exposure risks by continuing to hold domestic currency bonds.

The benefit to the bond issuer may be two-fold. One, perhaps the foreign issuer plans to use the proceeds in the market where the funds were raised. Two, perhaps the foreign company or government is located in a country with a small domestic bond market. By tapping a larger foreign market, they open up additional sources of financing opportunities.

Variable Rate Bonds

Bonds that have floating interest rates.

Interest is fixed for an initial period, often the first year of the bond’s term. After that initial period, the coupon rate fluctuates based on predetermined factors.

For example, ABC issues 10 year variable rate bonds. The terms are such that the bonds pay interest at the rate of 5% for the initial year. Afterwards, the bonds pay interest at “LIBOR plus 150 basis points” adjusted annually.

Note that the London Interbank Offered Rate (LIBOR) is a global benchmark for short term interest rates, similar to the “prime rate” in the US.

Note further that there are 100 basis points in 1.00%. In this example, 150 basis points equals a 1.5% adjustment.

Because of the changing interest rates on the debt, these bonds are usually redeemable at par value at the lender’s option on fixed dates or periods.

These bonds are useful during periods of fluctuating interest rates or uncertainty as to future rates. You do not want to lock into a bond for a 10 years earning 5%, when general interest rates have risen to 10%.

With interest rates, you also need to consider inflation. In periods of inflation, variable rate bonds may also be a good investment to protect against inflation driving up general interest rate levels.

Of course, the opposite is also true. If you can lock into a 30 year fixed rate bond at 10% and interest rates fall to 5%, great for you. But if that same bond is variable rate, you will suddenly be losing interest receipts on the rate adjustment.

Real Return Bonds

Real return bonds are indexed to the inflation rate.

Treasury Inflation-Protected Securities (TIPS) are a very popular form of real return fixed income investments. But there are others out there as well in different currencies, maturities, etc.

The objective is to ensure that nominal returns are not eroded by inflation and that investors receive a fixed real return on their investment.

Both the coupon and principal payments are indexed.

These bonds have a fixed real coupon. At each interest payment, the face value of the debt is adjusted for the cumulative inflation from the date the bond was issued. Then the real coupon rate is applied to the adjusted principal to determine the interest paid.

At maturity, investors are paid the original face value plus any cumulative inflation adjustments.

The benefit of these bonds for investors is as protection against substantial increases in inflation. When we reviewed inflation, we saw that it can impair interest income and even erode one’s original capital.

Zero Coupon Bonds

Zero coupon, or “strip bonds”, are like Treasury bills. Except much longer in term to maturity.

They do not pay any actual interest over the term of the bond.

If you think of these bonds as having no, or zero, coupon rate or that the coupon has been physically stripped from the bond, it may be easy to remember.

As an aside, if the interest coupons have been stripped from the bond issue, the coupons themselves can also be bought and sold as a separate investment. Essentially you pay the present value of the future interest payment streams.

Strip bonds are issued at a price equal to the net present value of of the bond, factoring in the term to maturity, the face value of the debt, and an implicit interest rate.

For example, you buy a 25 year, $1000 par, zero coupon bond priced to yield 11%. While the face value is $1000, you will only pay $68.77 for the bond.

You do not receive any interest receipts over the 25 years, so your purchase price is at a significant discount to make up for the lack of semi-annual cash flows.

Because of the reduced issue price, zero coupon bonds are often called “deep discount bonds”. In this example, you are only paying $68.77 for a bond that matures at $1000.00. Quite the discount!

Note that there are also “discount bonds”. These have lower than market coupons, but do pay some interest each period. As they pay less interest than they should, they issue the debt at a discount to face value to ensure the yield to maturity is adequate to attract investors.

The difference between the price paid by the investor and the face value is considered interest income for tax purposes.

Many countries require investors to pay tax yearly on the interest that is accrued each year, not when the cash is actually received. This would be calculated as the change in present value of the bond over the year.

Because you are paying tax on the deemed interest, you might end up with a negative cash flow each year as you pay tax without actually getting the interest.

Therefore, zero coupon bonds are most attractive to tax exempt investors or those who hold these bonds in tax deferred investment accounts.

I like zero coupon bonds when interest rates are high or are expected to fall over the coming years. As you saw in the example, for a relatively low investment, you can lock in a fixed return for a long period. In tax deferred accounts, zero coupon bonds are very useful for building long term wealth.

High Yield Bonds

Also known as “junk bonds” or “speculative grade debt”.

These bonds have been designated as non-investment grade debt by the ratings agencies. That is, these bonds have a higher risk of default than investment grade issues.

Ratings below BBB by Standards & Poors or Baa by Moody’s are considered non-investment grade bonds.

Because of the increased risk of default on interest and principal payments, high yield bonds offer higher returns than similar investment grade issues. Spreads are based on many factors, but may be between 300 – 600 basis points versus high quality bonds. So the potential extra returns can be attractive. Of course, the risks are correspondingly higher too.

Because of the risk, I would not normally recommend purchasing individual junk bonds.

However, if you acquire a mutual or exchange traded fund that holds a wide variety of high yield debt, you can diversify away a significant portion of the higher risk and still maintain an improved yield.

That is enough on types of bonds.

Next we will look at common bond features that impact price and yields.

Corporate Bond Variations

Governments and corporations may issue plain vanilla debt. At, or near, par with fixed, periodic interest payments.

Or they may add chocolate sauce or sprinkles. Like Baskins-Robbins, there are a multitude of options for the more adventurous debt issuers and investors.

Here are a few common bond variations you may see issued, mainly by corporations due to their nature. All of these potential features are utilized to attract investors. Thereby reducing the interest rates they would otherwise have to pay.

Note that the following are secured bonds, which we previously discussed.

Mortgage Bonds

Bonds that are backed by a pledge of real property, such as buildings or land, as collateral for the debt issue. Exactly like the mortgage on your home.

If the company defaults, bond holders have a claim to the pledged assets. Like your bank with your mortgage.

As I mentioned previously, you need to consider the liquidity and the market value of the collateral. Just because the pledged asset has a book value in excess of the bond issue does not mean that you will get that amount should you have to sell the asset to pay off the bond holders.

This same point applies to all the items below as well.

Note that mortgage bonds are not the same as “mortgage backed securities” (MBS). An MBS is a pool of mortgages that are bundled together. Units are then issued to investors who receive a flow through of interest and principal from the pooled mortgages.

Collateral Trust Bonds

Bonds where the corporation pledges financial securities (stocks and bonds) that it owns as collateral.

This is useful for companies that lack equipment, real estate, receivables, or operating facilities to use as collateral.

The riskiness of this is based on the liquidity and volatility of the pledged assets.

If the pledged securities are US government Treasury bills, then the risk is minimal. If the collateral is shares of small, private companies, then liquidity may be poor and the volatility very high. When the shares are doing well, there may be ample coverage for the debt issue. But if the shares enter a bear market (downward cycle), you may quickly find that there is not enough collateral to cover the debt issue.

Equipment Trust Certificates

Bonds issued by transportation companies where “rolling stock” is pledged as collateral.

“Rolling stock” is anything with wheels (automobiles, trains, airplanes, etc.).

In addition to liquidity issues, you need to consider market value versus book value.

Book value is the asset’s value on a company’s balance sheet. It will take purchase price and reduce the value each year for calculated depreciation.

Assume that a freight train will last 20 years, costs $10 million to buy, and will be depreciated by the same amount each year over its expected life. In this example, depreciation would be $500,000 each year. After the first year the book value would be $9.5 million. After year 10, $5 million. And after year 20, there is zero book value.

Market value though, is what the asset is actually worth on the open market.

After year 1, the book value is $9.5 million. However, if you want to sell the train and have time to wait for a proper buyer, you may only get $7 million for it. Or, if you need to immediately sell the asset tomorrow, you might only get $4 million under fire sale conditions.

Conversely, at the end of year 20 the book value is zero. But perhaps there is still some life in the asset and you are able to sell it for $1 million.

Book value is simply a calculation. It is the actual market value that is important when you need to buy or sell an asset.

Certificates for Automobile Receivables

Debt that is secured by loans on auto purchases.

Maybe you decide to purchase a new vehicle and finance the car through the auto company over 5 years. Other buyers around the world do exactly the same thing. The car maker then bundles all the loans together and pledges them against the debt issue.

The interest and principal that is paid to the car maker by the individuals should cover the interest and principal paid by the car maker to the debt holders.

By bundling a wide variety of individual loans together, the risk of default decreases and each separate loan has minimal impact on the overall loan portfolio. However, if there is a widespread economic catastrophe (e.g. a depression occurring) and many of the individual loans default, this will make payments by the car maker difficult.

Those are some common examples of debt issues along with a few things to think about. Key is the risk-return relationship. Any bond feature that reduces riskiness of investors receiving their interest and original principal, allows the issuer to pay less interest.

Typical Bond Issuers

Most investors never directly invest in bonds, excluding perhaps government savings bonds. Instead, you will probably invest in bonds indirectly through mutual or exchange traded funds. This is what I normally recommend to most investors.

So why is it useful to learn a bit about individual bond terms and different bond issues?

The global bond market is massive relative to the equity markets.

In 2014, total global financial assets were an estimated USD 294 trillion. Of that, USD 69 trillion related to global stock markets. The other USD 225 trillion was global fixed income. 76% of financial assets are debt.

If you invest, you will undoubtably own bonds, even if they are part of a fund or other collective investment scheme.

Today we shall look at the typical bond issuers.

Government Bonds

Various levels of government may issue debt instruments.

Government bonds are normally not backed by specific assets. Rather, they are only guaranteed by the government that issues them. So they are unsecured bonds or debentures.

Simply because a nation’s government guarantees its debts, does not mean they are completely safe or not at risk of default. You need to assess each country’s credit rating and relevant risk factors before investing your money in government bonds.

Traditionally, US government bonds were considered the safest bond to purchase. And, as you recall, the lower the risk, the lower the return that will be offered.

While US government bonds are still extremely strong, in March of 2010, Berkshire Hathaway issued 2 year notes at a 3.5 basis point yield less than similar US government notes. This means that the investment community considered Berkshire Hathaway, a public company, to be a lower risk than the US government.

An extremely rare occurrence; one that hopefully will not become common for US government debt issues in the future.

In the past, countries have restructured their debt terms or even defaulted on their bonds.

In 2002, Argentina defaulted on USD 1 billion in debt. In 2008, Ecuador. In 2015, Greece. Many examples out there.

Other countries (states, provinces, municipalities, etc.) have seen their credit ratings fall over time. This increases the cost of borrowing for the countries which puts further stress on each country’s cash flow. That can further increase the probability the country ultimately defaults.

Just because a government issues debt, do not assume it is risk-free.

I should also note that the fortunes of countries (states, provinces, etc.) can also recover. For example, Portugal was considered a risky country in 2010. Yet things have improved since then and their credit rating has strengthened to a degree. Some investors play these ups and downs for profit.

Government Agency Bonds

In certain countries, government agencies issue debt to the public. Examples of government agencies include the US Government National Mortgage Association (Ginnie Mae) or Canada’s Export Development Corporation.

While not directly government bonds, these debt issues are fully backed by the underlying government. In essence, government agency bonds will have the same credit worthiness as the government that is guaranteeing the debt.

Because of the government backing, these bonds are often called “indirect government bonds” or “guaranteed bonds”.

Municipal Bonds

Municipal bonds, or “munis”, are government bonds issued by states, counties, cities, or other lower level governments.

You may find “general obligation bonds” or “revenue bonds” in this category.

General obligation bonds are guaranteed by the issuer and supported through its complete power of taxation.

Whereas the interest and principal of revenue bonds are financed by the cash flow generated from the revenues of the specific project funded by the debt issue.

As general obligation bond interest and principal are covered by all tax sources rather than just the project being financed, they are a lower risk investment between the two. As such, all else equal, revenue bonds will offer higher returns than identical general obligation bonds.

Another important feature of a municipal bond is the tax paid by investors on interest receipts. If you live in the US and own a US based municipal bond, any interest receipts are exempt from US federal income tax. Often, these bonds are also exempt from taxes in the locality and state where the bond was issued.

Because many investors need not pay tax on interest receipts, the offered yields on the bonds are less than other non-tax exempt bonds with similar characteristics.

For example, say you reside in Maine and have a 30% marginal tax rate. You have two investment options. One a US government 5 year bond trading at par, with a coupon of 8%. The other, a local municipal 5 year bond also selling at par, with a coupon of 6%.

On the surface, the 8% yield appears better. However, you always need to consider the impact of taxes. It is the net return that is crucial, not the gross return.

In our example, the net return on the US government bond is only 5.6% [8*(1-0.30)]. A lower amount than the tax-free return of 6% with the municipal bond.

Be aware that one’s tax situation is unique to each person. Before investing in munis, or any other tax impacted investments, always determine the affect to you first.

Corporate Bonds

Like governments, corporations can raise capital through the issuance of debt.

As we discussed previously, debt may be secured by the company pledging specific assets against the issue. Or it may be unsecured, where the bonds fall into the general obligations of the company.

Corporate bonds may be issued in the same fashion as most government bonds. That is, a straight debt issue, with semi-annual interest payments over a fixed period of time. At the end of the term, the face value of the bonds is repaid to the debt holders and the issue is cancelled.

Straightforward bond issues such as these are known as plain vanilla bonds. There is no chocolate sauce, strawberries, or sprinkles on these debt instruments. We will look at slightly more exotic variations shortly.