When a loan is issued, it will be either secured or backed by full faith and credit. This idea applies to many types of borrowing, including bonds, mortgages, car loans, and student loans.
A bond is collateralized if it’s secured, meaning there is collateral backing the loan. A mortgage is a familiar example of a secured loan: if you don’t make the payments, the bank can take the home. Secured bonds work the same way. If the issuer fails to pay interest and/or principal, the collateral can be liquidated (sold), and the proceeds are used to pay bondholders. Common types of collateral include real estate, equipment, and subsidiaries.
If a bond is backed by full faith and credit - also called unsecured - there is no collateral. The bond is supported only by the issuer’s promise to repay. If the issuer fails to make payments, bondholders can sue, but there may be no assets available to recover the investment. If the issuer has little-to-no capital (money) left, bondholders could lose their entire investment.
Because secured bonds have collateral support, they’re generally safer. As a result, they’re typically issued with lower interest rates and trade at lower yields. Unsecured bonds carry more risk, so they’re typically issued with higher interest rates and trade at higher yields to compensate investors.
We first learned about call features in the preferred stock chapter. Bonds use the same concept.
If a bond is callable, the issuer can repay the bond’s principal (par) value before maturity, ending the bond early. When a bond is called, the issuer must pay bondholders:
After the bond is called, interest payments stop and the bond no longer exists.
Calling a bond is similar to paying off a loan early. The borrower repays principal and stops paying interest. That’s good for the borrower, but it can be bad for the lender, who may lose years of interest income. Callable bonds create the same tradeoff.
There are several reasons an issuer might call a bond. The most common is to refinance. Suppose an issuer has a $100 million bond outstanding with a 7% coupon, so it pays $7 million in annual interest. 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. That reduces annual interest from $7 million to $3 million, saving $4 million per year. This is the same basic idea as refinancing a loan.
An issuer might also call a bond simply because it has the cash available. If the issuer doesn’t need to borrow anymore, it may prefer to repay the debt rather than continue 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 and it was called, it would be difficult to replace that 7% yield in a 3% interest rate environment without taking 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 results in higher overall yields for investors.
We already learned about call protection and call risk in the preferred stock chapter. As a reminder:
Here’s a video breakdown of a question involving both call protection and call premiums:
Even if a bond isn’t callable, an issuer can still try to reduce its debt before maturity by buying bonds back in the market. Another approach is a tender offer, which is a formal offer to current investors to buy back their securities, typically at a premium to the market price.
A put feature is similar to a call feature, but the bondholder controls it.
If a bond is puttable, the bondholder can sell the bond back to the issuer at par value before maturity. Puttable bonds are especially attractive when interest rates rise.
When interest rates rise, bond prices fall because existing bonds have fixed coupons. If newly issued bonds offer higher interest rates than older bonds trading in the secondary market, the older bonds must trade at a discount to compete. Puttable bonds, however, should not trade at discounts. If you own a puttable bond, there’s no reason to sell it for less than $1,000 in the market - you can put it back to the issuer and receive par value.
Investors often exercise the put when interest rates rise so they can reinvest at higher yields. For example, if you hold a puttable 4% bond and interest rates rise to 8%, you can put the bond back to the issuer, receive your $1,000 par value, and then use that money to buy a newly issued bond with similar features paying 8%.
When interest rates change, bond market values change as well. Bonds with longer maturities and lower coupons tend to have the most price volatility.
When a bond has a long maturity, it tends to be more sensitive to interest rate changes. Time increases the impact of rate changes on price. Suppose you own a 1-year bond and a 20-year bond. If interest rates rise, the market value of both bonds will fall, but the 20-year bond will typically fall more.
Here’s the intuition:
When interest rates fall, long-term bonds typically rise more for the same reason: the higher coupon is locked in for many years, so investors are willing to pay more for it.
Bonds with lower coupons have more price volatility than bonds with higher coupons. To see why, compare two 10-year bonds:
If interest rates rise, both bonds fall in value, but the 2% bond typically falls more. The 10% bond pays more interest along the way, giving the investor more cash flow to reinvest at the new, higher rates. The 2% bond provides less cash flow, so more of its value depends on receiving par at maturity.
Another way to think about it: lower-coupon bonds are more likely to trade at a discount. If much of the investor’s return comes from the discount being “earned back” at maturity, the investor must wait longer to realize that value.
If interest rates fall, both bonds rise in value, but the 2% bond typically rises more. With a low-coupon bond, less of the return comes from periodic interest payments that would need to be reinvested at the new, lower rates. With a high-coupon bond, more cash is paid out sooner, and reinvesting that cash becomes less attractive when rates are falling.
Here’s a video breakdown of a practice question regarding price volatility:
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