Features

Secured vs. unsecured bonds

When a loan is obtained, it will either be secured or backed by full faith and credit. This applies to everything from bonds to mortgages to car loans to student loans. A secured bond is backed by something of value. A full faith and credit bond is backed only by the borrower’s promise to repay.

A bond is collateralized if it’s secured, meaning there is collateral backing the loan. Mortgages are secured loans: if you fail to make your mortgage payments, the bank can take your home. A secured bond works the same way. If the issuer fails to pay bondholders interest and/or principal, the collateral can be liquidated (sold), and the proceeds are used to pay bondholders. Examples of collateral pledged by bond issuers include real estate, equipment, and subsidiaries.

If a bond is backed by full faith and credit - also known as unsecured - it’s supported only by the issuer’s promise to repay the borrowed funds. If the issuer fails to make required payments, bondholders can still sue. However, there is no collateral backing the bond. If the issuer has little-to-no capital (money) left, bondholders could lose their entire investment.

Secured bonds are generally safer investments, so they’re typically issued with lower interest rates and trade at lower yields. To compensate investors for the additional risk, unsecured bonds are typically issued with higher interest rates and trade at higher yields.

Callable bonds

We first learned about call features in the preferred stock features chapter. Bonds work the same way. If a bond is callable, the issuer can repay the bond’s principal (par) value before maturity and end the bond early. When a bond is called, the issuer must pay bondholders the par value plus any call premium (discussed below). After the bond is called, interest payments stop and the bond ceases to exist.

Calling a bond is similar to paying off a loan early. The borrower repays the principal and no longer makes interest payments. That’s good for the borrower, but it can reduce the lender’s expected interest income. Callable bonds create the same trade-off.

There are a few reasons an issuer would call a bond. The most common is to refinance. Assume an issuer has a $100 million 7% bond outstanding, which means the issuer pays $7 million in interest annually. If interest rates fall to 3%, the issuer could sell a new bond with a 3% coupon and use the proceeds to call the older 7% bond. This reduces the interest rate by 4%, saving $4 million per year (from $7 million of annual interest down to $3 million). This is the same idea as refinancing a loan.

An issuer could also call a bond simply because it has the cash to do so. It’s similar to paying off a credit card balance early because there’s money in the bank. If the issuer doesn’t need to borrow anymore, it may not want to keep paying interest.

Callable bonds are issuer-friendly and generally not beneficial to bondholders. Bonds are often called when interest rates fall. If you owned the 7% bond in the example above and it was called, it would be difficult to find another bond yielding 7% in a 3% interest rate environment. To get a similar yield, you’d likely have to take on much more risk. This is an example of call risk.

Because callable bonds expose investors to call risk, they’re typically issued with higher interest rates than similar non-callable bonds. In the market, callable bonds also tend to trade at lower prices, which increases the overall rate of return offered to investors.

We already learned about call protection and call risk in the preferred stock chapter. As a reminder, call protection is the number of years before a security can be called. A call premium is any amount above par ($1,000) that an issuer must pay to call a bond.

Here’s a video breakdown of a question involving both call protection and call premiums:

Even if a bond isn’t callable, an issuer could still try to reduce its debt before maturity. One approach is to buy bonds back in the market. Another approach is a tender offer, which is a formal offer to investors to buy back their securities, typically at a premium to the bond’s current market value.

Put features

A put feature is similar to a call feature, except the bondholder controls it. If a bond is puttable, it allows the bondholder to sell the bond back to the issuer for its par value before maturity. Puttable bonds are attractive to investors, especially when interest rates rise.

When interest rates rise, bond values fall because the coupon is fixed. If newly issued bonds offer higher interest rates than older bonds trading in the secondary market, those older bonds must usually sell at a discount to compete. Puttable bonds, however, should not trade at discounts. If you own a puttable bond, why sell it in the market for less than $1,000 when you can put it back to the issuer and receive par ($1,000)?

Investors often put their bonds when interest rates rise so they can reinvest at higher rates. For example, if you hold a puttable 4% bond and interest rates rise to 8%, you could put the bond back to the issuer. The issuer pays you the $1,000 par value, and you can use that money to buy a newly issued bond with similar features offering an 8% rate of return.