An Introduction to the Bond Markets

4

Bond Options and Variants

When a bond is issued, especially if it is a long dated one, the issuer may want to have some flexibility about when it is repaid. This could arise, inter alia, because:

• the issuer's circumstances have changed in such a way that the loan is no longer needed or
• 1as interest rates have dropped, the issuer can refinance the loan more cheaply or
• the covenants on the loan prevent the issuer raising more capital in the most appropriate way.

Such an option that gives the issuer a right to redeem all or part of a bond early is called a ‘call’ option.

Another variant of this is when the issuer wants to redeem the bond in stages, instead of in one go, via a sinking fund. This may occur when the issue is relatively large compared to the size of the issuer.

In the case of collateralized mortgage bonds securitized with a pool of mortgages, the bond will be repaid according to when the underlying mortgages themselves are paid off. The bond is thus redeemed in a number of tranches of unknown size.

In a similar way, in order to make a bond more attractive to an investor, the issuer may grant the investor a variety of different options. These can vary from:

• a ‘put’ option, which gives the investor the right to request early repayment of the capital on a specific date or dates;
• having warrants to purchase other assets attached;
• automatically increasing the coupon rate, if the rating of the bond issue is reduced;
• having the right to convert the bonds at predefined rates ...