Bond Markets Fundamentals and Basics of Valuation (Chs. 11 and 12)
A bond (typically) pays a fixed coupon payment every six months until maturity and then returns the par value upon maturity.
Call Provisions A call provision refers to a provision of the bond that allows the issuer to buy back the bond prior to maturity for a fixed price. For example, if Southwest Airlines were to issue a 25-year 7% coupon bond they might include a call provision that would allow them to buy back the bond after 5 years for $1035. This would allow them to take advantage of a drop in interest rates by being able to buy back the bond for less than its underlying value (the value it would trade at if it didn’t have a call provision). The bond is callable anytime after five years. Some call provisions offer a declining premium as the bond gets closer to maturity (for instance, $1035 after 5 years and $1000 after 10 years). Callable bonds typically offer slightly higher yields than non-callable bonds.
Put Provisions A put provision refers to a provision of the bond that allows the bondholder to sell the bond back to the issuer for a fixed price prior to maturity. These are less common than call provisions and protect the bondholder from an increase in market interest rates or a deterioration of the credit quality of the bond issuer. Bonds with put provisions typically offer slightly lower yields than bonds without.
Convertible Provisions A convertible bond refers to a bond that can be exchanged for a fixed number of shares of stock at the discretion of the bondholder. The convertible bond offers some of the protection of a bond (coupon payment, par value returned at maturity, and better bankruptcy protection than common) with some of the upside of the stock (if the firm does exceptionally well and the stock price increases significantly, the bondholder can trade her bonds for stocks). This “best of both worlds” security does not come...