When a loan is obtained, it will either be secured or full faith and credit. This applies to everything from bonds to mortgages to car loans to student loans. If a bond is secured, it is backed by something of value. If a bond is full faith and credit, it is only backed by the borrower’s promise to pay back the loan.
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 will take your home. Similarly, if a bond has collateral backing their bond, it is secured in the same way. If the issuer fails to pay bondholders their interest and/or principal, the collateral will be liquidated (sold) and the funds will be passed on to the bondholders. Examples of collateral pledged by bond issuers include real estate, equipment, and subsidiaries.
If a bond is full faith and credit, also known as unsecured, it is only backed by the issuer’s promise to pay back the borrowed funds. If the issuer fails to make the required payments, they can still be sued by the bondholders. 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 safer investments, and therefore are typically issued with lower interest rates and trade at lower yields. To compensate their investors for risk, unsecured bonds are issued with higher interest rates and traded at higher yields.
Callable bonds
We first learned about call features in the preferred stock chapter. It’s exactly the same with bonds. If a bond is callable, it allows the issuer to pay back its principal (par) value prior to maturity and put an end to the bond earlier than maturity. When a bond is called, the issuer must pay accrued interest, its par value, and any call premium (discussed below) to bondholders. After the bond is called, the issuer no longer pays interest and the bond ceases to exist.
An issuer calling a bond is similar to a person paying off a loan early. They repay the principal of the loan to the lender and no longer make interest payments. The borrower is happy to stop paying interest, but the lender could be losing out on years of interest income. Callable bonds work the same way!
There are a few good reasons an issuer would call a bond. The most common is to refinance. Assume an issuer has a $100 million 7% bond outstanding, which results in the issuer paying $7 million in interest payments annually. If interest rates fall to 3%, they could issue a new bond with a 3% coupon and use the money raised to call the older, 7% bond. By doing so, they’ve reduced their interest rate by 4%, which results in saving $4 million in interest annually (going from paying $7 million in interest on the 7% loan to paying $3 million in interest on the 3% loan). If you’ve ever refinanced a loan, you know this process.
An issuer could also call a bond simply because they have money to do so. It’s similar to paying off a credit card loan because there’s money in the bank. Why would anyone pay interest on borrowed funds when they don’t need to?
Callable bonds are issuer-friendly and not beneficial to bondholders. More often than not, bonds are called when interest rates fall. If you owned the 7% bond referenced above and were called, it would be very difficult to find another 7% yielding bond in a 3% interest rate environment. In order to do so, you would need to seek out a much riskier bond. This is an example of call risk.
Because of the risk they expose investors to, callable bonds are issued with higher interest rates than similar non-callable bonds. While the feature is a benefit to issuers, it costs them because of the larger interest payment requirements. In the market, callable bonds trade at lower prices, which offer higher overall rates of return to their 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 of money 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 attempt to put an end to their debts earlier than maturity. They could simply go to the market and attempt to purchase as many bonds back as possible. Additionally, a debt issuer could also entertain issuing 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 its market value.
Put features
A put feature is similar to a call feature, except for who controls it. If a bond is puttable, it allows the bondholder to sell the bond back to the issuer for its par value prior to maturity. Puttable bonds are attractive to investors, especially if interest rates rise.
When interest rates rise, bond values fall because of their fixed coupon. If new bonds being issued today have higher interest rates than older bonds trading in the secondary market, those older bonds must be sold at a discount to make them marketable. However, puttable bonds should never trade at discounts. If you owned a bond that was puttable, why would you ever sell it in the market for less than $1,000? You could just put the bond back to the issuer and force them to pay back its par value ($1,000).
Investors tend to put their bonds when interest rates rise so they can lock in higher rates of return. If you held a puttable 4% bond and interest rates were to rise to 8%, you should put your bond. The issuer would pay you back your $1,000 par value, which could then be used to buy a newly issued bond with similar features providing an 8% rate of return.
Price volatility
When interest rates change, bond market values fluctuate in the market. Bonds with longer maturities and lower coupons tend to see the most price volatility.
When a bond has a long maturity, it tends to be more sensitive to interest rate changes. Time has a compounding effect on market values. Assume you own a 1-year bond and a 20-year bond in your portfolio. When interest rates rise, market values for both bonds will fall. The 20-year bond’s price will fall more in price. Let’s talk about why.
When interest rates rise, it makes current bonds less valuable. Existing bond values are dependent on the interest rates of new bonds. When interest rates rise, new bonds become more valuable (they’re being issued with higher rates than before), leading to existing bonds falling in value.
While both the 1-year and the 20-year bond will fall in value, the 1-year bond won’t fall as much. Within one year, the investor will receive their par value back. At that point in time, the investor can reinvest their money back into a new bond with a higher rate of interest.
The other bond has a 20-year wait until that can happen. It’s locked in at the lower rate of interest until it matures or is sold. This is why bonds with longer maturities fall further in price when interest rates rise.
When interest rates fall, long-term bonds rise further in price for the same reasons. Going back to our comparison, the 1-year bond will rise in price, but not by much. It matures within one year; if the investor decides to reinvest their money back in the market, they will buy a bond with a lower rate of return.
The other bond has a higher interest rate that’s locked in for the next 20 years. Because of this, the market value of the 20-year bond will rise much further than the 1-year bond.
Bonds with lower coupons have more price volatility than bonds with higher coupons. To understand 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 will fall further in price because it has less interest to reinvest back into the market at the new, higher rate of interest. The 10% coupon bond pays much more interest and gives more money to the bondholder to reinvest back into the market at the new, higher rate of interest.
The lower the coupon of a bond, the more likely it was sold at a discount. If a bond’s value is mostly from its discount, the investor must wait until maturity to make money from the bond’s discount. The 10% bond is more valuable in this situation because the 10% bond pays more interest that can be reinvested at higher rates right now.
When interest rates fall, the value of both bonds will rise. The 2% coupon bond will rise further in price because its value is likely tied to a discount. Remember, the lower the coupon, the more likely the bond was sold at a discount. When much of the bond’s value is achieved at maturity when the investor receives the par value of the bond, it is not required to reinvest large sums of money at lower rates of return.
The 10% bond pays much more interest to its bondholder. If the bondholder decides to reinvest their interest back into the market, they are forced to now buy bonds with lower rates of return as interest rates fall. The 10% bond is less valuable in this situation because the 10% bond pays more interest that would be reinvested at lower rates right now.
Here’s a video breakdown of a practice question regarding price volatility:
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