Fixed income securities, such as bonds, are often overlooked because their investing counterpart, equities, are often viewed as more Wall Street-esque and tend to steal the show. When overhearing investing conversations you will mostly hear about the latest IPOs and what stocks are making the largest moves for the day, not anything related to bonds. However, this does not mean they are not important. Fixed income securities such as bonds are imperative in creating a well diversified portfolio and can limit several different types of risk.
A built-in or embedded perk that some bonds have are that they are callable, putable, or convertible. This article will describe the differences between these three provisions and discuss how they can be beneficial to the bond issuer or the bondholder.
Callable bonds are bonds that give the issuer the right to redeem or buy back all or part of the bond before it matures. A call provision is beneficial to the issuer because if they are able to issue bonds at a lower interest rate they can call the bonds and do so. Issuing bonds at lower interest rates simply means that it will cost the issuer less. The interest rates can decrease for several reasons, two of which are that the market interest rate falls, or the issuer’s credit quality improves which means they can offer debt at lower rates.
When an investor purchases a bond in general, they are usually expecting a fixed stream of coupon payments at a stated rate as well as a return of their principal. Because the issuer can call the bonds in the chance of lower interest rates, this exposes the bondholder to reinvestment risk: the risk that future coupon payments from a bond will not be able to be reinvested at the rate the bond was initially purchased at. The combination of the reinvestment risk the bondholder bears, and the option given to the issuer of taking advantage of lower interest rates means that callable bonds usually sell at a lower price than similar non-callable bonds.
There are three different types of callable bonds, their differences being when the issuer can buy or redeem their outstanding securities.
- American Style: also known as a continuously callable bond, an American call lets the issuer call the bond at any time after the first call date.
- European Style: the issuer can only call the bond on the specific call date.
- Bermuda Style: a combination of the American and European style where the issuer has the right to call the bonds on specific dates following a call protection period.
A putable bond is a bond that gives the bondholder the ability to sell the bond back to the issuer at a predetermined price on predetermined dates. Putable bonds can either offer one sell-back opportunity (European style), or multiple sell-back opportunities (Bermuda style) which are generally more expensive than one-time put bonds.
Unlike callable bonds, a bond with a put provision is an added benefit for the bondholder: if market interest rates rise, which will decrease the current prices of bonds because they were sold when interest rates were lower, the bondholder can sell the bond back to the issuer and then reinvest the proceeds into a bond that offers a higher rate. Putable bonds will most likely cost more than similar bonds without a put provision and also have a lower yield to compensate the issuer.
A convertible bond is where the bondholder has the right to exchange the bond for a specified number of the company’s common shares. There are several benefits for the bondholder that a convertible bond has over a non-convertible bond, the first being that convertible bonds allow the investor to take advantage of a price appreciation in the company’s shares. For instance, if the share price appreciates 25%, the bondholder has the option of converting the bond into shares and could then sell them. Additionally, the bondholder is given downside risk protection by purchasing a convertible bond instead of purchasing shares outright: if the share price of the common shares depreciate, the bondholder will still receive regular coupon payments and the repayment of their principal. If the investor only purchased company shares, they would not have any type of downside risk protection (unless they bought options).
Although it seems on the surface that this type of bond only benefits the bondholder, there are several advantages to the issuer as well. Because the convertible provision is an added benefit for the bondholder, the bond will offer a lower yield than otherwise similar non-convertible bonds, saving the issuer on interest expense. Additionally, some of the issuer’s debt will be eliminated if the bondholders exercise their right to convert the bond into common shares.
Understanding the different types of bonds and their associated benefits is important to all investors. Fixed income securities such as bonds might not have the same reputation as equities, however they offer many embedded income generating advantages and have risk diversifying elements that equities alone do not.