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.