Question

Provide a description of how bonds work and the cashflows associated with a bond issuance. Also, discuss the relationship between interest rates and the value/price of an existing bond. Provide an example of an additional provision that may be included with a bond and the impact on the coupon rate that adding this provision would have at the time of issuance. Finally discuss when a company would be motivated to exercise a call provision on the bond and the risk to which this exposes the bondholder.

Answer 1

A bond is a debt instrument issued by a government, firm, etc. to raise funds. Bonds can issued in domestic market or international bond market. They pay a fixed coupon or interest rate periodically, specified at the time of the issue. Coupon rate can be paid annually, semi annually, quarterly, etc., it depends on the terms of issue. They are redeemed at the end of the term for example, a 10 year bond will be redeemed at end of 10 years. They can be redeemed at par i.e. face value or at a premium i.e. face value + some additional amount.

A bond whose coupon rate is more than market interest rate, trades at a premium i.e. it is priced at more than face value in the market. Likewise, A bond whose coupon rate is less than market interest rate, trades at a discount i.e. it is priced at less than face value in the market. But at maturity, bond's price is equal to its face value due to convergence.

Additional provision such as call option may be included with a bond. Callable bond is a bond, which can be redeemed at a fixed call price, any time before the maturity, at the option of the issuer. Issuer would usually call the bond if it is trading at a heavy premium in the market. To compensate the investor, for loss suffered by him due to early calling of bond, callable bonds usually carry higher coupon rates than regular bond. Likewise, a put option can be included with a bond. It gives bondholder the right to redeem bond at a fixed price any time before the maturity. Bondholder would usually redeem his bond if the bond is trading at a heavy discount in the market. Coupon rates offered on puttable bonds are usually lower than regular bond.

A company would be motivated to exercise a call provision on the bond if the prevailing interest rates in the market are lower than those offered on the callable bond. And when interest rates in the market are lower than the coupon rates, the bond trades at a premium.