3. Calling a Bond : Expect the unexpected

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Introduction to Financial Markets

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Indian School of Business

Introduction to Financial Markets

748 classificações

Curso 1 de 5 em Specialization Financial Markets and Investment Strategy

Learn the general concepts of financial markets and economy. You will see the difference between primary and secondary markets and learn about markets for different products. You will also look at various economic Indicators and their influence on the markets. After completing this course, you will have a much stronger background of financial markets and ready to go to the next stage in the Specialization. This course is designed to help students with very little or no finance background to learn the basics of investments.

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Fixed Income Markets

In this module you will be exposed to the fixed income markets. Various types of fixed income securities available in the market are discussed. Learners are also taught the bond terminology.

1. Bonds : What are they?6:13

2. Interest Rates or Yields : Finding Direction9:11

3. Calling a Bond : Expect the unexpected7:57

4. Bond Ratings : Necessary, not Optional11:29

Conheça os instrutores

Vaidya Nathan
Lecturer
Finance

Learning Outcomes, after watching this video,

you will be able to explain what calling a bond means.

You will also be able to understand and explain

when it is economically beneficial for the bond issuer to call the bond.

Calling a Bond, Calling a bond means that the issuer exercises

the right to repay the principle of the bond before the maturity date of the bond.

Most bonds today should now have this call provision, i.e,

they have the right to call a bond before the bond actually matures.

Now this right, or this call provision, gives the issuer greater

flexibility to respond to changes in the general level of interest rates.

For example, if a corporation had issued a bond way back in 2005 or 2006,

when interest rates were high, and it was let's say a 20 year bond,

then the corporation is obligated to provide a very high interest rate for

the next 20 years from 2005 to 2025.

The corporation would have to pay a high interest rate.

On the other hand, if the bond had a call provision,

then what the issuer can do is basically call back the bond or

retire the bond and reissue the bond at a lower interest rate.

So, if the bond has been issued in a period of high interest rate, and

if interest rate subsequently declined,

to a level that the same bond could be issued at a lower coupon, then,

it would be in the corporation's advantage to retire the old bond and

reissue new bonds at a lower interest rate.

In fact, this savings on interest cost can be so significant,

often it can be in millions of dollars for a bond, which has issue size

of a billion dollars or more.

And typically, issuers redeem the bond at a premium above the face value,

and normally the premium amounts to one year of interest rates.

So for instance, if a bond had a coupon of say 10%, and

the face value of the bond was $1000, it might be called at $11000,

i.e., a premium of 10% which is the coupon of the bond.

Most bonds are not subject to a call provision

until a specified number of years that have elapsed.

Typically, these are five years or ten years in long term bonds.

So, after that period, the bond can be called at any time,

at a specified price of the issuer that the issuer stipulates or

it can be done no typically once in a year, for

all the years until the first call date.

So, in addition to this optional call method,

a lot of bonds can also be retired through what is called a Sinking Fund.

Now, once a Sinking Fund is established,

the issuer must kind of keep aside an amount of money each year for

periodic retirements of this particular bond issuance.

Now this normally enhances the security of the remaining bonds,

because now the issuer has to pay less as

part of the bond has been repaid back, has been bought back using the sinking fund.

When new bonds are issued,

investment bankers often say that they are floating a new issue.

So it's understandable that a bond retirement program or a bond retirement

fund is actually called a sinking fund, as opposed to floating of new issues.

You're basically retiring bonds, and that's what is called a Sinking Fund.

So the bonds to be retired each year can either be called at a specified price,

or they can even be purchased in the open market at the price that's prevailing.

Occasionally the sinking fund payments are allowed to accumulate, while

earning interest so that the entire issue can eventually be retired at one time.

So if you are an investor, and if you ignore a call feature,

you could be subject to an expensive surprise.

You could be surprised, and that surprise could be pretty expensive for

you in terms of money.

So if the bonds are unexpectedly called,

you as a bond holder might get the principal amount back sooner,

but you may actually lose what may have been an attractive yield.

So, if you recall the example that I discussed earlier, so

a corporation which had issued a bond in 2005, a 20 year bond and the bond had

a fairly high coupon because the interest rates, pre-crisis, were higher then.

And if you are the holder of the bond, you could be enjoying a high interest rate,

a high return, a high coupon on the bond for the next 20 years.

But then if the issuer of the bond decides to call the issue, you may be in for

an expensive surprise in the sense that now if you have to get back the money and

buy a new bond, then that particular bond will typically earn you much less.

The coupon would be much lower than what this bond,

which was issued pre-crisis, in say 2005.

It was 20 year bond, so you could have got a lot of very high interest

payments over a 20 year time period, but because the bond has been

called you may not be enjoying the benefits of the high interest rate.

Now on the other hand, for the corporation, it's a good feature to have

because if a corporation had issued a bond at a fairly high interest rate,

and then interest rates in general came down over a period of time,

then you now have the flexibility to retire the old bond and

basically reissue bonds at a much lower interest rate.

So now if you as a bond holder do not cognize for

this call feature, as I said, you could be in for

an expensive surprise because you may even lose part of your principal.

Now this would occur if a bond had been purchased at a substantial premium,

but it has been called at a price close to par.

So let's say interest rates went down, and you bought the bond at

a fairly high price, because the interest rates are usually lower.

And then you basically now have the principal returned to face value,

because a bond is now called, you could potentially lose money.

So you have to be very careful in terms of the call feature of bonds.

And so, for these reasons, you as a potential board investor,

should carefully examine the call and the sinking fund provision with your broker,

or the bond dealer to better understand the risks that are involved.

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