Bonds can be issued with special features that affect their investment value, risk-and-return profile, and marketability. This chapter covers:
Loans can be either secured or full faith and credit (unsecured). This idea applies to all debt instruments, including bonds, mortgages, and personal loans.
A secured bond is also described as collateralized, meaning the bond is backed by collateral. Mortgages and car loans are common examples: if you don’t make payments, the lender can take the home or car.
Collateralized 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. For example, a corporation might issue a mortgage bond backed by a factory it owns. If the corporation can’t make the required interest and/or principal payments, the factory must be sold and the sale proceeds are paid to bondholders.
Full faith and credit bonds have no collateral backing. If the issuer fails to make the required payments, bondholders can still sue, but there’s no specific asset pledged to support repayment. If the issuer has no assets or money left, bondholders can lose their entire investment.
Because secured bonds have collateral backing, they’re generally safer and therefore offer lower rates of return. Unsecured bonds are riskier, so they typically offer higher rates of return to compensate investors for taking on that additional risk.
We first learned about call features in the preferred stock chapter. The concept is the same for bonds.
A callable bond allows the issuer to repay the bond’s principal (par) value before maturity and redeem the bond early. When a bond is called, the issuer must pay bondholders:
After the bond is called, interest payments stop and the bond is retired.
Calling a bond is similar to paying off a loan early. The borrower repays principal and stops making interest payments. That’s good for the borrower, but it reduces the lender’s future interest income. Callable bonds create the same trade-off: the issuer benefits, and the bondholder may lose expected interest payments.
Issuers may call bonds for several reasons. The most common is to refinance (also called refunding). For example, suppose an issuer has $100 million of 7% bonds outstanding, so it pays $7 million in annual interest. If interest rates fall to 3%, the issuer could sell new bonds at 3% and use the proceeds to call the older 7% bonds. That reduces annual interest from $7 million to $3 million, saving $4 million per year.
An issuer might also call a bond simply because it has the cash available. If the issuer can eliminate interest expense by paying off debt early, it may choose to do so.
Callable bonds are issuer-friendly and generally less favorable for 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 replace that 7% yield in a 3% interest-rate environment without taking on more risk. This is call risk.
Because call features add risk for bondholders, issuers typically compensate investors by offering higher interest rates on callable bonds. Without that added incentive, callable bonds can be difficult to sell in the primary market. In the secondary market, callable bonds tend to trade at lower prices (because they’re less desirable), which increases their overall rate of return. In general, the lower the purchase price, the higher the potential rate of return.
Issuers may reduce call risk by offering call protection or a 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 can still try to reduce or eliminate debt early by buying its bonds in the secondary market. Any bonds the issuer repurchases are effectively retired (the issuer doesn’t pay interest to itself). The issuer could also make a tender offer to current bondholders. A tender offer is a formal offer to buy back securities, typically at a premium to their market value.
A put feature is similar to a call feature, but the bondholder controls it. A put feature allows bondholders to sell the bond back to the issuer before maturity for par value plus any accrued interest. Puttable bonds are attractive to investors, especially when interest rates rise.
When interest rates rise, bond prices tend to fall because the bond’s coupon is fixed. If new bonds are being issued with higher coupons than your bond, your bond becomes less attractive and may need to trade at a discount to sell.
For example, suppose you own a 5% bond while new bonds are being issued with 8% coupons. Your 5% bond would likely have to be sold in the secondary market at a discounted price. However, a put feature changes that decision. If your bond is puttable, you can put it back to the issuer and receive $1,000 (par), so you wouldn’t want to sell it for less than $1,000 in the market.
Investors often exercise (use) the put feature when interest rates rise so they can reinvest at higher yields. If you hold a puttable 5% bond and rates rise to 8%, exercising the put feature allows you to receive your $1,000 par value and use it to buy a new bond offering an 8% rate of return.
Sign up for free to take 20 quiz questions on this topic