Investing in Bonds 101: Concepts
Part 3 or 3, page 1
Bond Redemption Features
Earlier it was described how the maturity date of a bond was an important consideration when looking at a bond's yield. It also helps to set the expectation in the investor's mind as to how long a bond will remain issued to the public. Some bonds, however, contain certain redemption features you need to be aware of before making any purchases.
The Call Provision
A common redemption feature is a call provision, namely on corporate or company bonds. This is simply stated a provision which allows the issuer of a bond to redeem the debt instrument before its maturity date. Before investing in a bond, always ask if the bond has a call provision, or is callable. If so, ask about the "yield to call" in addition to the “yield to maturity” of the bond.
The reason a company or corporation might exercise its right to a call provision has to do with interest rates. Let us say interest rates drop dramatically between the date a bond is issued and its maturity date, a company or corporation may be better off redeeming bonds issued in order to reissue bonds at a much lower interest rate to save them a lot of money.
The call feature benefits a company or corporation which issues the bond and the investor assumes the risk when a bond will be redeemed before maturity, and they do not earn the expected interest they had hoped for. The investor does get back their entire initial investment. To compensate an investor for this risk and further entice investor’s to buy this type of bond, bonds issued with a call provision will usually pay a higher interest rate or have a premium provision whereby the company or corporation pays the bond holder a premium when the bond is called.
Average Life
Another feature you need to learn about when investing in bonds is a statement of "average life." This feature is unique to mortgage backed securities (MBS) (bonds issued by the mortgage industry) where the homeowner has the ability to prepay, refinance a mortgage or simply sell the home when moving from the home therefore paying off a mortgage.
If you are a homeowner you may have experience this with mortgages and you should understand this concept. In recent past, interest rates on mortgages fell dramatically and many homeowners refinance their homes. Added to this is the fact that the national average is about 17 people (or families) move from their homes each year. This causes many mortgages to be redeemed before their maturity dates. The yield on these types of bonds is usually stated over the average life span of the debt - bond.
Bond Puts
The same way some bonds contain a call feature, others contain a put feature. When interest rates go up, or continue to rise, a put feature allows investors to force the issuing company to repurchase the bond. This frees up an investor's money which allows them to reinvest in different bonds with higher interest rates - yields.
As this feature benefits the investor, the issuing company is compensated for the additional risk with lower interest rates than those without the put feature.
If this website helped you find your financial future we ask you to please give as a way to say Thank You. Not only does it support this site, is is a way to give it forward so others may find their way toward financial security. Please consider giving. Thank You.
