Question

Bond issuers (firms) will call bonds when it is favorable for them to do so. The benefit the issuer receives is a cost to the bondholders. Explain at least two ways in which bondholders are protected from calls.

First method: ________________

.
The second method: _______________

Answer 1

1. One method is to purchase a call protection which is a provision in these bonds to avoid these callable bond from being called for a certain time interval. During this call protection interval, coupon payments all happen as usual but not after the ending of this interval. The bond can be called at any point after the ending of call protectionperiod as per the issuer needs. Call protection can only protect the bondholders from interest rate risk in the particular call protection period which is also called the cushion period.

2. Laddering is one another method which can be used to reduce the reinvestment risk that arise from callable bonds being called by issuer when interest rates are moving down. Here as the principal is returned by issuer to bondholders, the money now will be reinvested at a lower interest rate causing losses for the investors.One way of tackling this issue is to create something called a bond ladder which is essentially a portfolio consisting of bonds with multiple varied maturity dates. As the financial market is generally cyclical in nature, interets rates may fall and then rise for different maturities different manner. This when we have a portfolio of bonds with multiple maturities, the impact of interest rate movement in different bonds with different maturities will be different allowing the possibility of losses from bonds of one maturity to be offset by gains of bonds of another maturity.