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 is 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 is supported only by the issuer’s promise to repay the borrowed funds. If the issuer fails to make the required payments, bondholders can still sue. However, there is no collateral set aside for bondholders. 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 issued with higher interest rates and trade at higher yields.
We first learned about call features in the preferred stock chapter. Bonds work the same way.
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, the issuer stops paying interest and the bond no longer exists.
Calling a bond is similar to paying off a loan early. The borrower repays the principal and stops making 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 for bondholders.
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 down to $3 million).
An issuer could also call a bond simply because it has the cash available. It’s similar to paying off a credit card balance because there’s money in the bank - why keep paying interest if you don’t need to borrow?
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 7% bond 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 yields for 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 can still try to reduce its debt before maturity. For example, it can go into the market and buy back bonds. It can also make a tender offer to current bondholders. A tender offer is a formal offer to investors to buy back their securities, typically at a premium to the bond’s market value.
A put feature is similar to a call feature, except the bondholder controls it.
If a bond is puttable, the bondholder can 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 of their fixed coupon. If newly issued bonds have higher interest rates than older bonds trading in the secondary market, those older bonds must trade at a discount to be competitive. 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 value ($1,000)?
Investors tend to 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 can put the bond back to the issuer, receive your $1,000 par value, and use that money to buy a newly issued bond with similar features paying 8%.
When interest rates change, bond market values fluctuate. 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 amplifies the effect of rate changes on price. Assume you own a 1-year bond and a 20-year bond. When interest rates rise, the market value of both bonds will fall - but the 20-year bond’s price will fall more. Here’s why.
When interest rates rise, newly issued bonds offer higher yields, which makes existing bonds (with lower coupons) less attractive. Existing bond prices must fall to compete.
Both the 1-year and the 20-year bond will drop in value, but the 1-year bond has less time remaining. In one year, the investor receives par value back and can reinvest at the new, higher rates. The 20-year bond locks the investor into the lower coupon for much longer unless the bond is sold. That longer lock-in is why long maturities fall further when rates rise.
When interest rates fall, long-term bonds rise more for the same reason. The 1-year bond will rise, but it matures soon, and the investor will have to reinvest at lower rates. The 20-year bond keeps paying its higher coupon for many years, so investors are willing to pay more for it, pushing its market value up more than the 1-year bond.
Bonds with lower coupons have more price volatility than bonds with higher coupons. To see this, assume you own two 10-year bonds: one has a 2% coupon and the other has a 10% coupon.
When interest rates rise, the value of both bonds will fall. The 2% coupon bond typically falls further because it pays less interest along the way, so the bondholder has less cash flow to reinvest at the new, higher rates. The 10% coupon bond pays more interest, giving the bondholder more money to reinvest at higher rates sooner.
Lower-coupon bonds are also more likely to have been sold at a discount. If much of the investor’s return comes from the discount, the investor must wait until maturity to realize that portion of the return. In a rising-rate environment, the higher-coupon (10%) bond is more valuable because it delivers more interest income that can be reinvested at higher rates right away.
When interest rates fall, the value of both bonds will rise. The 2% coupon bond often rises more because a larger portion of its value may come from receiving par at maturity, which doesn’t require reinvesting large interest payments at the new, lower rates. The 10% bond pays more interest, and if the bondholder reinvests that interest, it will now be reinvested at lower rates. That makes the higher-coupon bond relatively less valuable when rates fall.
Here’s a video breakdown of a practice question regarding price volatility:
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