Bonds can contain certain features when issued, which impact their investment worthiness, risk & benefit profile, and general marketability. We’ll discuss the following in this chapter:
Loans can be either secured or full faith and credit (unsecured). This concept applies to every debt-related instrument, from bonds to mortgages to personal loans. If a loan 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 repay the loan.
A bond is collateralized if secured, meaning collateral backs the loan. Mortgages and car loans are secured; the bank will take your home or car if you fail to make payments. Collateralized bonds are backed similarly. If the issuer fails to pay bondholders their interest and/or principal, the collateral will be liquidated (sold), and the proceeds will be passed on to the bondholders. For example, a corporation issues a mortgage bond that is backed by a factory owned by the business. If the corporation cannot make the required interest and/or principal payments, the factory must be sold, and the sales proceeds are funneled to the bondholders.
Full faith and credit bonds are only backed by the issuer’s promise to repay the borrowed funds. If the issuer fails to make the required payments, the bondholders can still sue them. However, there is no collateral backing the bond. Bondholders will lose their entire investment if the issuer has no assets or money left.
Secured bonds are safer investments and therefore maintain lower rates of return. Unsecured bonds are issued with higher rates of return to compensate bondholders for the risk they’re exposed to.
We first learned about call features in the preferred stock chapter. This feature is exactly the same with bonds. A callable bond allows the issuer to pay back its principal (par) value before maturity and redeem the bond early. When a bond is called, the issuer must pay bondholders any accrued interest, its par value, and any call premium (discussed later in this section). After a 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. You repay the loan’s principal to the lender and no longer make interest payments. You’re happy to stop paying interest, but the lender lost out on future interest income. Callable bonds work the same way!
Issuers could have a few motivations for calling a bond. The most common reason 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 at 3% and use the money raised to call the older 7% bond. By doing so, they’ve reduced their interest rate by 4%, saving $4 million in annual interest (going from paying $7 million in interest on the 7% loan to paying $3 million 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. This scenario is similar to paying off a credit card loan because you have money in the bank. Why would anyone pay interest on borrowed funds when they don’t have 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, finding another 7% yielding bond in a 3% interest rate environment would be difficult. You would need to invest in a much riskier bond to do so. This is an example of call risk.
Call features are risks to bondholders. Therefore, issuers of callable bonds must compensate their investors and typically do so by issuing them with higher interest rates. If there isn’t an added motivation to buy a callable security, an issuer will have a difficult time selling it in the primary market. In the secondary market, callable bonds trade at lower prices (because they’re less desirable), which offer higher overall rates of return to their investors. The lower the price a bond can be purchased at, the higher the rate of return (more risk, more return)!
Issuers can provide call protection or a call premium to make the call feature less risky. Call protection represents the years before a bond can be called. If a 20 year bond issued today can’t be called for the first 10 years, the bond has 10 years of call protection. A call premium is any amount of money above par ($1,000) that an issuer must pay to call a bond. For example, if a bond is callable at $1,030, it has a $30 call premium.
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 redeem (end) their debts early. They could go to the secondary market and purchase as many bonds as possible. Every bond repurchased from the market would essentially be redeemed (the issuer wouldn’t pay interest to itself). They could also entertain issuing a tender offer to the current bondholders. A tender offer is a formal offer to investors to buy back their securities, typically at a premium to its market value.
A put feature is similar to a call feature, except for who controls it. Put features allow bondholders to sell bonds back to the issuer for the par value plus any accrued interest before 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 a higher interest rate than your bond, your bond is only marketable at a discounted price. Think about it - assume you own a 5% bond when new bonds are being issued in the primary market with 8% coupons. Your 5% bond would only be able to be sold in the secondary market at a discounted price (like selling a beat-up car for cheap). However, puttable bonds should never trade at discounts. If your bond was puttable, why would you ever sell it for less than $1,000? You could simply “put” it 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 to lock in higher rates of return. If you held a puttable 5% bond and interest rates were to rise to 8%, it would make sense to exercise the put feature. The issuer would pay you back your $1,000 par value, which could then be used to buy a new bond with an 8% rate of return.
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