LM01 Fixed-Income Securities: Defining Elements

Part 5

6. Callable and Putable Bonds

A contingency provision is a clause in a legal document that allows for some action if the event or circumstance does occur. It is also called an embedded option.

6.1 Callable Bonds

A callable bond gives the issuer the right to redeem all or part of the bond before the specified maturity date. Investors face reinvestment risk with callable bonds, as it is not possible to reinvest the proceeds at the previous higher interest rates. To compensate this risk to an extent, issuers offer a higher yield and sell at a lower price than the respective non-callable bonds.

Why companies issue callable bonds?

• To protect the issuer when market interest rates drop.
• Interest rates drop when market interest rates fall or the credit quality of the issuer improves. The issuer has an opportunity to call the old bonds and replace them with new cheaper bonds by saving on otherwise higher interest expenses.
• Companies also issue callable bonds to signal the market about their credit quality.

The following details about a callable bond are included in the indenture:

• Call price: Price paid by the issuer to the bondholder when the bond is called.
• Call premium: The amount paid on top of the face value as compensation to bondholders as they will have to reinvest proceeds at a lower rate.
• Call schedule: The dates and prices at which the bond may be called.
• Call protection period: It is also known as the lockout period, deferment, or cushion period. During this period, a bond may not be called by the issuer. It is typically in the early days of a bond’s life to encourage investors to invest in the issue.
• Call date: The earliest date at which a bond may be called.

The three types of callable bonds based on exercise styles are listed below:

• American call: The issuer has the right to call the bond any time after the first call date.
• European call: The issuer has the right to call the bond only once after the first call date.
• Bermuda-style call: The issuer has the right to call the bond on specific dates after the call protection period.

Example

Assume a hypothetical 20-year bond is issued on 1 December 2012 at a price of 97.315 (as a percentage of par). Each bond has a par value of $100. The bond is callable in whole or in part every 1 December from 2017 at the option of the issuer. The callable prices are shown below.

1. What is the call protection period?
2. What is the call premium (per bond) in 2021?
3. What type of a callable bond is it most likely?

Solution:

1. The bonds were issued in 2012 and are first callable in 2017. The call protection period is 2017 – 2012 = 5 years.
2. The call prices are stated as a percentage of par. The call price in 2021 is $102.23 (102.23% × $100). The call premium is the amount paid above par by the issuer. The call premium in 2021 is $2.23 ($102.23 – $100).
3. It is a Bermuda call. The bond is callable every 1 December from 2017 – that is, on specified dates following the call protection period. Thus, the embedded option is a Bermuda call.

6.2 Putable Bonds

A putable bond gives the bondholder the right to sell the bond back to the issuer at a pre-determined price on specified dates. Putable bonds offer a lower yield and sell at a higher price relative to otherwise non-putable bonds. Putable bonds are beneficial to the bondholder because:

• When interest rates rise, bond prices fall. If the selling price is pre-specified, bondholders may put (sell) back the bond to the issuer at that price, which is higher than the market price when interest rates rise.
• Cash can be reinvested at higher rates.

The following details about a putable bond are included in the indenture:

• Redemption dates.
• Selling price; usually equal to the face value of the bond.
• How many times the issuer allows bondholders to sell the bond during the bond’s life.
• One-time put: Gives bondholders a single sellback opportunity.
• Multiple put: More than one sellback opportunity available. Priced higher than one-time put bonds.

Like callable bonds, putable bonds are also classified into three, based on their exercise styles:

• American put: Bondholder has the right to sell the bond back to the issuer any time after the first put date.
• European put: Bondholder has the right sell the bond back to the issuer only once on the put date.
• Bermuda-style put: Bondholder has the right sell the bond back to the issuer only on specified dates.

7. Convertible Bonds

A convertible bond is a hybrid security with both debt and equity features. It gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing company.

Some terms associated with the conversion provision are given below:

• Conversion price: Price per share at which the convertible bond can be converted into shares.
• Conversion ratio: Number of shares that each bond can be converted into.

Conversion ratio =

• Conversion value: Current share price multiplied by the conversion ratio. It is also called the parity value.

Conversion value = current share price * conversion ratio

• Conversion premium: Difference between the convertible bond’s price and its conversion value.

Conversion premium = convertible bond’s price – conversion value

Warrant: A warrant is an attached option, not an embedded option. It gives the bondholder the right to buy the underlying common shares at a fixed price called the exercise price any time before the expiration date.

Contingent Convertible (CoCo) Bonds: These are bonds with contingent write-down provisions. The bonds can be converted into equity contingent to a specific condition. For example, a CoCo bond might be allowed to be converted into equity only after it reaches a certain price.

Example

Assume that a convertible bond issued in the United Kingdom has a par value of £1,000 and is currently priced at £1,200. The underlying share price is £56 and the conversion ratio is 25:1. What is the conversion condition for this bond?

Solution:
The conversion value of the bond is £56 × 25 = £1,400. The price of the convertible bond is £1,200. Thus, the conversion value of the bond is more than the bond’s price, and this condition is referred to as above parity.

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