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Bonds with embedded options

A bond with contingency provision is a bond which entitles either the issuer or the bondholder to take some action on the occurrence of some event. A contingency provision is a legal clause included in the bond indenture which entitles issuer/bondholder to an option called embedded option. It is embedded because it cannot be traded separately. Examples of bonds with embedded options include callable bonds (which are most common), putable bonds and convertible bonds.

Callable bonds

A callable bond is a bond which the issuer can redeem at any time before the maturity date. It protects the issuer from a decline in interest rates (either due to a decrease in market interest rates or an improvement in the issuer’s credit quality) by allowing it to retire the old expensive bond and issue a new bond at a lower interest rate. But since a call provision increases the reinvestment risk for bondholders (because they would receive bond cash flows earlier than expected and that too in a low-interest environment), they must be compensated by a higher yield.

A bond indenture contains details about call provision such as call price, the price at which an issuer can retire a bond; call date (or a schedule of call dates), the earlier date on which the bond may be called; call premium, the excess over premium which must be paid if the bond is called.

Some bonds have a call protection period, a period in which the bond may not be called. A make-whole call provision requires the issuer to pay an amount equal to the present value of remaining bond cash flows discounted at a predetermined discount rate (which equals yield on sovereign bonds plus a spread). Since such a value is typically much higher than the current market price of the bond, it acts as a ‘sweetener’ for bondholders but is rarely exercised by issuers.

Some bonds which may be called only once on the call date are called European-style callable bonds, others which can be called anytime after the call date are called American-style callable bonds, and still others which can be called on either of the call dates listed in the call schedule are called Bermuda-style callable bonds.

Putable bonds

A putable bond is a bond which entitles the bondholder to sell the bond back to the issuer at a specified price (usually par) on a specified date (in the case of European-style bonds) or dates (in case of Bermuda-style bonds).

Who benefits from putable bonds

When interest rates rise, bond prices fall, but a putable bond’s price does not because the bondholders have an option to sell the bonds back to the issuer at par and invest the proceeds in new bonds paying higher interest rates. This is how a putable bond benefits a bondholder when interest rates rise. But putable bonds are expensive to start with i.e. they offer lower yields than callable bonds or plain-vanilla bonds. This low yield compensates the issuer for the possibility of having to redeem bonds before expiry. Putable bonds are particularly attractive to conservative bondholders because the put option enables them to convert their bonds to cash in a downturn before other investors can do so. This results in improved liquidity.

Convertible bonds

A convertible bond is a bond which the bondholder can convert to common shares of the issuer. It is a combination of a straight bond and an equity call option.

A convertible bond allows an investor to participate in the equity upside by giving him an option to convert to common stock when the share price appreciates. It also offers downside protection because its value cannot decline below the value of a straight bond. These advantages make a convertible bond expensive and the issuers benefit from lower required yield, and hence low coupon rate and elimination of debt when conversion option is exercised.

Conversion price, conversion ratio, convesion value and conversion premium

The conversion price is the price per share at which a convertible bond can be converted to common shares.

The conversion ratio is the number of common shares that each convertible bond is entitled to.

Conversion value (also called parity value) is the current equity-equivalent value of a convertible bond and it equals the product of current stock price and conversion ratio.

Conversion premium is the excess of convertible bond price over its conversion value. Conversion parity occurs when conversion value is equal to the convertible bond price.

Convertible bonds typically have maturities in the range of 5-10 years and up to 3 years in case of first-time/younger issuers.

Conversion decision

Bondholders typically exercise conversion options close to maturity because the yield on convertible bonds is higher than dividend yield. Convertible bonds typically have a call provision too which enables the issuer to call the bonds when the conversion value is above the current share price. Therefore, callable convertible bonds must offer a higher yield than non-callable convertible bonds. However, some indentures specify a minimum share price below which a bond may not be called to limit unpredictability of the share price at which bonds are called.

Contingent convertible bonds (CoCos)

Some bonds have a warrant, an equity option, attached to them. Such an option is not embedded because it can be sold by the bondholder separately. They are used as a yield enhancement too. Some convertible bonds issued by European banks, called contingent convertible bonds (CoCos) have a write-down provision that triggers automatic conversion when a specified event occurs. Unlike the traditional convertible bonds which are converted when stock price rises, CoCos are triggered when something adverse happens. Therefore, they must pay a higher yield. They are frequently used by banks to shore up their capital in the event of any adverse situation. When an adverse action such as breach of capital adequacy ratio, etc. occurs, CoCos are triggered automatically resulting in an increase in equity and reduction in risk of default.

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