Investing in bonds — Redemption features

WHILE the maturity period is a good guide to how long a bond will be outstanding, certain bonds have structural features that can substantially change the expected life of an investment. Call provisions Some bonds have call provisions. This provision gives the issuer the right but not an obligation to buy back the underlying bond from investors at a price (call price) specified at the time when the bond was issued.

In this case, the issuer pays the investor a call price together with total interest accrued to that date.

Issuers typically exercise this option when the prevailing interest rates significantly drop from the time the bond was issued.

The issuer of the bond can thus essentially refinance debt at more favourable terms when interest rates fall.

Bonds with call provisions usually have a higher annual return to compensate investors for the risk that the issuer might buy back the bond before maturity.

Execution of a call provision by the issuer forces the investor to reinvest his / her money at lower interest rates that are unattractive.

Put provisions Conversely, some bonds have put provisions. This provision gives the investor the right but not an obligation to sell the bond back to the issuer at a price that was specified at the time the bond was issued.

Investors typically exercise this option when interest rates have significantly risen since the issuance of the bond.

The investor can thus reinvest the proceeds at more favourable terms after an increase in interest rates.

As a result, bonds with put provisions have lower annual returns to compensate issuers for the risk that an investor might sell back the bond before maturity.

Execution of a put provision by the investor forces the issuer to raise money at higher interest rates that are more expensive.

Investors are therefore advised to familiarise themselves with any underlying redemption features before investing in a bond for informed decision making purposes.