Bonds occasionally come with embedded options and other features, which are written in each bond’s offering documents. These can have the effect of adjusting a bond’s maturity date, and change the expected returns on the bond. Not all bonds have unusual features (those that don’t are considered plain vanilla bonds); however, it is important for investors to understand how they work and how they can affect one’s investment returns and the pricing of a bond.
Bank Guarantee or Letter of Credit
Keepwell agreements or a letter of support can be enhanced by the inclusion of a bank guarantee or letter of credit. This additional support by the bank comes at an additional cost to the issuer, but significantly enhances the credit quality of the bond, since bondholders can now look towards the bank for legal recourse in the event that the issuer defaults.
Calls and Puts
Some of the most common forms of embedded options include “calls” and “puts”. Typically, bonds with such features are structured with “issuer calls” or “bondholder puts” – the former allows an issuer to redeem a bond prior to the maturity date at a predetermined price (and date), while the latter allows the bondholder to request the issuer to redeem the bond prior to maturity; again, this will be at a predetermined price and date.
Bonds with callable features are thus commonly termed “callable bonds”, while those with a put option are commonly termed “puttable bonds”. It is also fairly common for bonds to be structured with a “change-of-control put” option. This usually serves the purpose of allowing bondholders the right to repayment prior to the maturity date, in the event of a takeover of the company.
Coupon Reset
A common feature in perpetual bonds, a coupon reset results in the coupon rate being changed according to a specified formula, on specified date(s). For investors, this mitigates the interest rate risk and serves as a possible disincentive for the issuer to keep the bonds outstanding. The absence of a coupon reset encourages the issuer to keep the bonds outstanding if interest rates rise, while a decline in rates would see the issuer call the bonds early, leaving no duration benefit for the bondholder.
The reset rate is typically tied to a reference rate plus a slated margin, e.g. 5Yr Annual Swap Rate + 4.698%.
Coupon Step-up
Referring to a step-up (and thus increase) in bond coupon rate, this feature also provides investors with the benefit of keeping up with potentially rising interest rates. While some bonds may only have a single step-up feature, others may offer multiple step-ups throughout their lifetime. These step-ups may also be offered based on certain conditions being met, such as the bond not being called, change-of-control events, covenant breaches and so on.
Deferred Interest Payment
Bonds with such a feature allow issuers to cancel interest payments and defer them indefinitely, or for a specified period, without triggering a default. In some scenarios, the issuer may not be limited in terms of the maximum number of times interest can be cancelled or deferred. In the event of a cumulative deferral, any missed interest payments are still legally owed to the investor. As for a non-cumulative deferral, these are permanently forgone.
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. If the bond provides the holders with the option to extend the maturity, it is priced as a puttable bond. Should the right lie with the issuers, it is likely to be priced as a callable bond.
Keepwell Agreements
Keepwell agreements can sometimes be drafted as a form of credit enhancement for a bond – this is usually an agreement between the parent company and the subsidiary (which is the issuer), where the parent agrees to keep the issuing subsidiary in good financial healthy, by maintaining certain financial ratios or levels of equity.
Unlike a guarantee, keepwell agreements are not legally binding, and depending on the way such agreements are drafted, they can be similar to a parent guarantee or simply having perfunctory or superficial enhancement qualities for the particular bond. Where the terms of the keepwell agreement are loosely drafted, like in the case of a “letter of support”, investors have minimal recourse to the issuer’s parent.
Loss Absorption
A feature typically found in bonds issued by banks, loss absorptions allow them to write-down the principal amount and/or cancel accrued interest, or effectively write-off their bond obligation upon a trigger event. These trigger events are usually linked to capital adequacy ratios or concerns by regulators over the bank’s financial viability.
Make-Whole-Call Provision
While it is also common for corporate bonds to be structured with a “make-whole-call” provision, such calls are rarely triggered by issuers, due to the significant cost involved. In the event of a make-whole-call, the issuer has to make a one-off payment that is equivalent to the net present value of all future coupon payments (not paid because of the call) from the bond – these are usually discounted at a predetermined rate (e.g. Treasury rate plus a spread).
This is usually a superior outcome compared to a traditional issuer call, in which case all future coupon payments are discontinued given the early termination of the bond. Bondholders will essentially see their investment “made whole” as a result prior to the maturity date; the triggering of a “make-whole-call” provision is usually a positive outcome for the bondholder.
What this means for investors
For bonds with additional features, the simple use of a yield to maturity measure may not be sufficient for analysis, given that the presence of these options can significantly adjust the bond’s maturity date. Measures like “yield to call” become more important in the assessment of callable bonds – these can be calculated with the knowledge of the terms for each call date and price; it is commonplace for callable bonds to be referenced by a “yield to worst” measure, which is the lower of the yield to maturity or yield to call.
Credit enhancement features can be viewed favourably by investors, giving them more confidence in bonds that carry these features. However, as it may result in the bond receiving a higher credit rating, this may also result in lower coupon rates.
Effect on bond price
In general, bond features can either add to or subtract from the value of a bond, depending on whether the option is a benefit to the bondholder or the issuer.
For example, the presence of an embedded issuer call option is a benefit to the bond issuer, and detracts from the certainty of returns for the bondholder. As a result, a bond with an issuer call feature should, in theory, trade at a discount (or provide a higher yield) compared to a bond without such a feature, assuming all other things are constant. In contrast, a bondholder put option (which allows the bondholder to require the issuer to redeem the bond at a predetermined date) benefits the bondholders. As such, a bond with such a feature would likely trade at a premium (or have a lower yield) compared to one without such a feature, again assuming all other things are held constant.
