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.
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?
The following details about a callable bond are included in the indenture:
The three types of callable bonds based on exercise styles are listed below:
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.
|2026 and thereafter
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:
The following details about a putable bond are included in the indenture:
Like callable bonds, putable bonds are also classified into three, based on their exercise styles:
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.
|Advantages of Convertible Bonds
|From investor’s perspective
|From issuer’s perspective
|Opportunity to convert into equity if share prices are increasing and participate in upside.
|Reduced interest expense; lower yield than otherwise non-convertible bond because of the conversion provision given to bondholders.
|Downside protection if shares prices are falling.
|Elimination of debt if conversion option is exercised. So they do not have to repay the debt.
|Convertible bonds are usually callable.
Some terms associated with the conversion provision are given below:
Conversion value = current share price * conversion ratio
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.
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?
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.