Contingency Provisions in Bonds | CFA Level I Fixed Income
In this article, we’ll explore contingency provisions, a significant component of bond indentures. We’ll discuss different types of embedded options and their implications for both issuers and bondholders.
Contingency Provisions: An Overview
Contingency provisions, also known as embedded options, are clauses in bond indentures that allow specific actions if certain events or circumstances occur. These options can’t be traded separately and can be exercised by either the issuer or the bondholders. Bonds without embedded options are called straight bonds or option-free bonds.
Issuer-Exercisable Options: The Call Provision
The call provision is an embedded option that allows the issuer to redeem all or part of a bond before its maturity date. This can be valuable for the issuer, especially when interest rates decrease, allowing them to refinance at lower rates.
A company issues a 10-year bond with a 9% coupon rate. Three years later, market interest rates drop, and the company can borrow at 6%. If the bond has a call option, the issuer can redeem the outstanding debt and issue new debt at the lower rate.
Callable bonds come with reinvestment risk for bondholders, as they may receive lower interest rates on reinvested funds. To compensate for this risk, callable bonds generally offer higher yields than similar non-callable bonds.
Call Provision Specifics
Callable bonds may have a call protection period, during which the issuer cannot call the bond. The call date is the earliest possible time for calling the bond. Some bonds may have multiple call dates.
The call price is the amount paid to bondholders when the bond is called. This price may include a call premium to compensate bondholders for the early redemption. The call schedule lists the dates and prices at which a bond may be called.
There are three main types of call options:
- European style: Bonds can only be called on the specified call date.
- American style: Bonds can be called anytime after the first call date.
- Bermuda style: Bonds can be called on specific dates after the first call date, often on coupon payment dates.
An alternative to the traditional call provision is the make-whole call provision, which reduces reinvestment risk for bondholders. With this type of provision, the call price is based on the present value of the bondholder’s future cash flows, ensuring the issuer doesn’t benefit from lower interest rates when calling the bond.
Bondholder-Exercisable Options: The Put Provision
The put provision is similar to the call option, but it benefits bondholders by giving them the right to sell the bond back to the issuer at a predetermined price on specified dates. This can be advantageous if interest rates rise, allowing bondholders to reinvest in higher-yielding bonds.
Like callable bonds, puttable bonds have different exercise styles:
- European style: Bonds can only be put on the specified put date.
- American style: Bonds can be put anytime after the first put date.
- Bermuda style: Bonds can be put on specific dates after the first put date.
The redemption price for most puttable bonds is the face value of the bond. Since put provisions are valuable to bondholders, puttable bonds generally offer lower yields compared to similar non-puttable bonds, compensating the issuer for the value of the put option to the investor.
Convertible Bonds: Another Option for Bondholders
A convertible bond is a type of bond that gives bondholders the option to exchange the bond for a specific number of shares of the issuer’s common stock. These bonds combine the safety of bonds with the growth potential of stocks, offering investors a unique opportunity to diversify their investment portfolio.
Why Convertible Bonds Appeal to Investors
Bonds offer investors downside protection through regular cash flow and principal protection. However, they have limited upside potential, as the principal is returned upon maturity. Stocks, on the other hand, provide unlimited upside potential but no downside protection.
Convertible bonds seemingly offer the best of both worlds:
- If the company’s stock price underperforms, the bondholder can treat the convertible bond as a straight bond, collecting regular coupon payments and receiving the principal at maturity.
- If the company’s stock price performs well, the bondholder can exercise the conversion option and participate in the equity upside.
Advantages for Issuers
Convertible bonds offer two main advantages for issuers:
- Reduced interest expense: Issuers can offer lower coupon rates because of investors’ attraction to the conversion feature.
- Elimination of debt: If the conversion option is exercised, the debt is eliminated.
However, existing shareholders may not be pleased with the dilutive effect of conversions on their shares.
Here are some key terms related to convertible bonds:
- Conversion price: The price per share at which the bond may be converted to common stock.
- Conversion ratio: The number of shares received for each converted bond, calculated by dividing the bond’s par value by the conversion price.
- Conversion value: The market value of the shares that would be received upon conversion.
- Conversion premium: The difference between the bond’s price at the time of conversion and the conversion value
Alternatives to Convertible Bonds
Issuers can also include warrants with straight bonds or use contingent convertible bonds (CoCos) to provide bondholders with an opportunity for additional returns when the company’s common shares increase in value.
Warrants give bondholders the right to buy the company’s common shares at a given price over a given period. Like convertible bonds, bondholders can wait for the stock price to appreciate before exercising the warrants. After exercising the warrants, the bondholder becomes both a bondholder and a stockholder of the company. The main difference between warrants and convertible bonds is that, after exercising the warrant, the investor still holds both the bond and the stocks, whereas with convertible bonds, the investor only holds the stocks after exercising the conversion option.
Contingent Convertible Bonds (CoCos)
CoCos are bonds that automatically convert into common stock if a specific event occurs. These bonds are often used by banks to maintain specific levels of equity financing. If a bank’s equity capital falls below a given level, CoCos are automatically converted to common stock, helping the bank meet its minimum equity requirement. However, CoCos force bondholders to take losses, and as a result, they must offer a higher yield than otherwise similar bonds.
In summary, convertible bonds offer investors a unique investment opportunity by combining the safety of bonds with the growth potential of stocks. Issuers also benefit from reduced interest expenses and the potential elimination of debt. Alternatives to convertible bonds, such as warrants and CoCos, also provide bondholders with equity-like returns. As we delve deeper into fixed income topics in the CFA Level I curriculum, we’ll explore these concepts in more detail.