Question

The importance of knowing the terms of bond issues, especially those relating to redemption, cannot be overemphasized. Yet there have appeared numerous instances of investors, professional and others, who acknowledge that they don’t read the documentation. For example, in an article published in the New York Times, the following statements were attributed to some stockbrokers: “But brokers in the field say they often don’t spend much time reading these [official] statements,” “I can be honest and say I never look at the prospectus. . . . Generally, you don’t have time to do that,” and “There are some clients who really don’t know what they buy. . . . They just say, ‘That’s a good interest rate.’” Why is it important to understand the redemption features of a bond issue?

Answer 1

Why is it important to understand the redemption features of a bond issue?

~ There are some bonds that are issued with simple features like a fixed maturity and a fixed redemption value. However, there are bonds that come with embedded options or other features, which change the way the bonds should be valued.

~ In such cases, the yield rate, the value of bond, the risk, etc. changes, and the investors should be aware of these terms of the bonds, and how to evaluate it.

~ Such features and terms are written in each bond’s offering documents. Therefore, it is important to read the offer documents of a bond.

~ Following are the examples of such features:

Callable Bonds:

~ Callable bonds are bonds with an embedded call option. This call option gives the issuer of bond the right to call the bond back (buy back) at fixed call dates and call prices.

~ Issuers usually call the bonds back when the interest rates have declined sharply, and the market prices of bonds have increased. At such time, issuers will exercise the call option to buy back the bond at a lower call price. The issuer can then re-issue bonds the lower market interest rates, hence benefitting themselves.

~ Hence, in such a case, the investors have to sell the bond back at a lower price.

~ Therefore, the investors must know about these call features, and use metrics like Yield to Call, etc.

Putable Bonds:

~ Putable bonds have the opposite features of callable bonds. Putable bonds give the investors the right to sell the bond back to the company at a fixed put exercise price and fixed put dates.

~ This feature benefits the investors when the market interest rates have risen, and the bond values have fallen, then the investors can exercise the put option and sell the bond at a higher price (exercise price).

Extendable Tenor:

With this, bond holders or issuers are given the right to extend the maturity of the bond. Investors may be interested in such bonds as it allows them to take advantage of the changing interest rates without immediately taking on the risk of holding a long-dated bond.

~ Hence, it is important for the investors to read the offer documents of the bond to know about such redemption features that completely changes how a bond investment should be analyzed.