Lecture Note Five:

Bonds with Other Features

FINA0804/3323 Fixed Income Securities
Faculty of Business and Economics
University of Hong Kong
Dr. Huiyan Qiu
5-1

Outline
Callable bond
What is a callable bond? Why callable bond?
Pros and cons of calling a bond
Valuing a callable bond

Convertible bond: Basics

Floaters and inverse floaters
Repurchase agreement
Reference: Fabozzis chapter 17, 19
5-2

Bonds with Embedded Options

A bond with an embedded option is one where
either the issuer or the bondholder has the
option to alter a bonds cash flows.
The traditional pricing method and yield spread
analysis however assume bonds cash flows are
fixed.
The most common type of embedded option is a
call option.
Such bonds are referred to as callable bonds
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What is a Callable Bond?

A callable bond allows the issuer to buy back
the whole issue at a pre-specified price at some
point in the future.
Some terms
The strike price (or exercise price or call price):

the price at which the issuer can buy back the

bonds (typically par value plus one years
interest).
Call protection period: the period during which
the issuer cannot call the bonds.
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Why Callable Bond?

Callable bonds give borrowers the option to
refinance when interest rates are low. In other
words, it is one way companies hedge against
possible decreases in future interest rates.
Before 1970 almost all corporate bonds were

issued with call features.

Between 1970 and 1990, about 80% of fixed rate
corporate bonds were callable.
Now, less than 30% of corporate bonds are callable
due to the development of the interest rate
derivatives markets.
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Why Callable Bond? (contd)

Some firms may still find callable bonds
desirable because by issuing callable bonds they
can send a strong positive signal to the markets
about the quality of their business.
If a firm is confident about their business and

believes that their credit quality will improve in

the future (which will lower their borrowing costs),
it makes sense for them to issue a callable bond.
As soon as the market realizes their better values,
they can simply call the old expensive bond and
replace it with a bond which pays lower coupons.
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Callable Bondholders
The presence of a call option results in two
disadvantages to the bondholder.
Disadvantage 1: Callable bonds expose
bondholders to reinvestment risk:
Investors are exposed to additional reinvestment
risk due to the call option.
Issuers will call the bonds when the price of the
bond is higher than the strike price, which
happens when the interest rate is low enough.
Bondholders are forced to reinvest the proceeds
received in redemption at a lower interest rate.
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Callable Bondholders (contd)

Disadvantage 2: The price appreciation
potential for a callable bond in a declining
interest-rate environment is limited:
As interest rate drops, the price of a straight debt
will increase (in theory, no limit). However, in the
case of callable bonds, bonds are expected to be
redeemed when interest rate drops, therefore we
have a limit on the price appreciation. This is
called price compression.

Investors are willing to accept the call risk if

higher yield is offered.
5-8

Issuers: Reasons for Calling a Bond

There can be different reasons for a bond issuer
to call a bond.

1. To remove an undesirable protective

covenant in the bond indenture
2. An improved credit rating
3. Drop in the market-wide interest rate

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To Remove an Undesirable Covenant

An old debt indenture requires the firm to have
an interest coverage ratio of at least 2
Interest coverage ratio = Earnings before
interest and taxes divided by Interest expense

The firm wants to lower this requirement to 1.5

but has failed to negotiate with old bond holders
The firm can call the old bond (if the old bond is
callable) and issue new ones where the new
required interest coverage ratio is 1.5
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An Improved Credit Rating

If the rating of a firm has improved, for example,
from junk (below BBB) to investment grade
(BBB and above), the firm may consider calling
the old bond
The firm can now issue debt at a more favorable
rate
Investors are willing to accept a lower yield to
maturity or lower coupon rate because the firm
has become less risky

5-11

Drop in the Interest Rate

If the market-wide interest rates drop, the firm
may want to call the old bond (with a higher
coupon rate) and replace it by a lower-coupon
bond
The firm gains the present value of the coupons
saved
The new bond may or may not have a longer
maturity than the old bond

5-12

Pros and Cons of Calling a Bond

By calling a bond and refunding by issuing a new
bond, the firm usually benefits from a lower
coupon rate the firm gains the present value of
the coupons saved.
This saving has to be balanced against the costs
of calling a bond, which include:
Paying the call premium.
Flotation costs for the replacement bond issue
The loss of the opportunity to call the bond in the
future if interest rates were to drop even further.
The timing of calling is very crucial.
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Refunding Benefit: Example 1

Suppose there is a $100-par perpetual callable
bond with the following characteristics:
Coupon rate = 10%
Strike price = $100
No call protection
Suppose all interest rates drop to 7%. Then
Calling the old debt
Issuing new debt at 7%
If the costs of refinancing are 1.25% of par, what
is the refunding benefit?
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Refunding Benefit: Example 1

Refunding benefit
= ($3/0.07) ($100 1.25%)
= $42.86 $1.25 = $41.61
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Refunding Benefit: Example 2

Suppose a firm issued a semi-annual par coupon
bond with the following characteristics:
Maturity = 30 years
Par = $100
Coupon rate = 12%
Strike price = $105
Call protection for the first 5 years
At the end of the 5th year, rates are 9%.
5-16

Refunding Benefit: Example 2

There are 25 years remaining. The present value
of the firms liability if the debt is not called is
$129.64.
N = 50, PMT = 6, Rate = 4.5%, FV = $100.
If the bond is called at the strike price and a
new bond is issued with a 9% coupon rate.
The coupon rate is reduced by 3% for 25 years.

Present value of coupon saving is $29.64. (N = 50,

PMT = 1.5, Rate = 4.5%, FV = $0).
The call premium is $105 $100 = $5.
5-17

Refunding Benefit: Example 2

Suppose the flotation costs are 2% of par. The
overall refinancing costs is
Refinancing costs = Flotation costs + Call
premium = (2% $100) + ($105 $100) = $7

Refinancing benefit = PV of savings

Refinancing costs = $29.64 $7.00 = $22.64

5-18

Valuing a Callable Bond

Callable
bond can be considered as having two
components: a non-callable bond and a call
option.

A valuation model must produce arbitrage-free

values; that is, a valuation model must produce a
value for each on-the-run issue that is equal to
its observed market price. To price the bond we
will use a binomial interest rate tree model.
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Valuing a Callable Bond (contd)

The construction of binomial interest rate tree will be
covered in later lecture. We take the following tree as
given.

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Valuing a Callable Bond: Example

Consider a three-year bond with 5.25% annual
coupon payment. We employ the backward
induction methodology to compute the price of
bond (non-callable or callable at par in one year.)
Following figure shows the calculation of the
price of the bond that is callable at par in one
year. The slides followed provide the detail of the
calculation.
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Valuing a Callable Bond

5-22

Calculation
If the bond is not called in year 2, the price of the
bond then is
At node NHH, $105.25/1.067573 = $98.5881
At node NHL, $105.25/1.055324 = $99.7324
At node NLL, $105.25/1.045296 = $100.6892
At node NLL, the bond will be called since the
bond price is higher than the strike price $100.
There are $5.25 coupon payment at the end of
year 2.
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Calculation (contd)
the bond is not called in year 1, the price of the
If
bond then is
At node NH,
At node NL,

At node NL, the bond will be called since the bond

price is higher than the strike price $100.
There are $5.25 coupon payment at the end of
year 1.
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Calculation (contd)
At node N, now, the bond price is
The price of the callable bond is $101.4307.
For the non-callable bond, the price of the
bond at node NL is

5-25

Calculation (contd)

The
price of the non-callable bond at node N,
now, is
Therefore, the value of the option embedded in
the callable bond is

5-26

Option-Adjusted Spread
Option-adjusted spread (OAS)
OAS is the spread such that the market price of a

security equals its model price when discounted

values are computed at risk-neutral rates plus
that spread.
Assume the 5.25% callable three-year coupon bond
in our example is currently selling for $100.7874
(versus $101.4307 previously calculated). The OAS
of the callable bond is then 45 basis points.
Note: the computation can be done using trial and
error method or solver in excel.

5-27

What is a Convertible Bond?

A convertible bond is a bond with a call option
to buy the common stock of the issuer.
At the discretion of the bondholder, the convertible
bond can be converted into a predetermined
amount of the companys equity at certain times
during its life.

Exchangeable bonds grant the bondholder the

right to exchange the bonds for the common stock
of a firm other than the issuer of the bond.

5-28

Convertible Bond: Basics

The number of shares of common stock that the
bondholder will receive from exercising the call
option of a convertible bond or an exchangeable
bond is called the conversion ratio.
Upon conversion, the bondholder typically receives
from the issuer the underlying shares. This is
referred to as a physical settle.
There are issues where the issuer may have the
choice of paying the bondholder the cash value of
the underlying shares. This is referred to as a
cash settle.
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Conversion Value and Minimum Value

The
conversion value of a convertible bond is
the value of the bond if it is converted
immediately

The minimum value of a convertible bond is the

greater of
its conversion value, and
its straight value (the value without the
conversion option)

5-30

Market Conversion Price

The
market conversion price is the price that
an investor effectively pays for the common stock
if the convertible bond is purchased and then
converted into the common stock

5-31

Why Pay a Premium?

An investor who purchases a convertible bond
rather than the underlying stock typically pays a
premium over the current market price of the
stock.
As the stock price declines, the price of the
convertible bond will not fall below its straight
value. The straight value acts as a floor for the
convertible bond price.
The investor realizes higher current income from
the coupon interest paid on the convertible bond
than would be received as dividends paid on the
number of shares equal to the conversion ratio.
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Investment Characteristics
The investment characteristics of a convertible
bond depend on the stock price
If the stock price is low the straight value is

considerably higher than the conversion value

no conversion
Bond equivalent or busted convertible

If the stock price is high

Equity equivalent
Between the two cases
Hybrid security

5-33

Convertible Bond: Example

XYZ convertible bond:
Maturity = 10 years
Coupon rate = 10%
Conversion ratio = 50
Par value = $1,000
Current market price of the bond = $950
Straight value (the value of the non-convertible
bond) = $788

Current market price of XYZ common stock =

$17; Dividends per share = $1 per year
5-34

Convertible Bond: Example (contd)

Conversion value = $17 50 = $850
Market conversion price = $950 / 50 = $19
Market conversion premium per share
= $19 $17 = $2
Market conversion premium ratio = 2/17 11.8%
The bondholder receives $100 annual coupon
payment versus $50 dividend if the bond is
converted into 50 shares. ($2 per share versus $1
per share.)
5-35

Downside Risk with a Convertible Bond

The
downside risk of convertible bond is often
estimated by comparing the market price of the
bond with the straight value since the price of
the bond cannot fall below its straight value
The downside risk is measured as a percentage
of the straight value
The higher the premium over straight value, all
other factors constant, the less attractive the
convertible bond.
5-36

Downside Risk with a Convertible Bond

Despite its use in practice, the measure of
downside risk is flawed because the straight
value (floor) changes as interest rates change.
An advantage of buying the convertible rather
than the common stock is the reduction in
downside risk.
The disadvantage of a convertible relative to
the straight purchase of the common stock is the
upside potential give-up because a premium per
share must be paid.
5-37

Pros and Cons of Investing in a Convertible Bond

Suppose that an investor is considering purchase
of the XYZ stock or the XYZ convertible bond.
The stock can be purchased in the market for $17
By buying the convertible bond, the investor is
effectively purchasing the stock for $19

One month later, XYZ stock rises to $34, with

everything else remaining the same
The stock investor would realize a gain of $17 and
a return of 100%.
The bond holder would realize a gain of $1,700
$950 = $750 and a return of 79%.
5-38

Pros and Cons of Investing in a Convertible Bond

One month later, XYZ stock falls to $7, with
everything else remaining the same.
The stock investor buying the stock would realize
a loss of $10 and a return of 59%.
The bond holder would realize a loss of $950
$788 = $162 and a return of 17%.

Downside risk is reduced as the bondholder

has the opportunity to recoup the premium per
share through the higher current income from
owning the convertible bond.
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Pros and Cons of Investing in a Convertible Bond

Call risk: convertible issues are callable by the
issuer.
Most convertible bonds are callable (for the issuer)
and some are puttable (for the bondholder).

Takeover Risk
Corporate takeovers represent another risk to

investing in convertible bonds.

As the stock of the acquired company may no
longer trade after a takeover, the investor can be
left with a bond that pays a lower coupon rate
than comparable-risk corporate bonds.
5-40

Options Approach to Valuation

investor who purchases a non-callable /nonAn
puttable convertible bond would be entering into
two separate transactions:
buying a non-callable/non-puttable straight bond
buying a call option on the stock, where the
number of shares that can be purchased with the
call option is equal to the conversion ratio

5-41

Options Approach to Valuation

Consider a common feature of a convertible bond:
the issuers right to call the bond.
If called, the investor can lose any premium over

the conversion value that is reflected in the

market price.
Therefore, the analysis of convertible bonds must
take into account the value of the issuers right to
call the bond.
This depends, in turn, future interest rate
volatility, and economic factors that determine
whether it is optimal for the issuer to call the bond
5-42

Options Approach to Valuation

The Black-Scholes option pricing model cannot
handle this situation.
Instead, the binomial option pricing model can be

used simultaneously to value the bondholders call

option on the stock and the issuers right to call
the bonds.
The bondholders put option can also be
accommodated.
To link interest rates and stock prices together,
statistical analysis of historical movements of
these two variables must be estimated and
incorporated into the model.
5-43

Floating Rate Note: Introduction

A floating rate note (FRN) is a bond with coupon
rate reset periodically accordingly to a
benchmark interest rate, or indexed to this rate.
Possible benchmark rates:
US Treasury rates, LIBOR, prime rate, ....
The coupon rate on a floating rate note is often
equal to the benchmark interest rate plus a
premium (called spread).
5-44

Floating Rate Jargon

Other terms commonly used for floating-rate
notes are
FRNs
Floaters and Inverse Floaters
Variable-rate notes (VRNs)
Adjustable-rate notes
FRN usually refers to an instrument whose
coupon is based on a short term rate (3-month Tbill, 6-month LIBOR), while VRNs are based on
longer-term rates (1-year T-bill, 2-year LIBOR)
5-45

Cash Flow Rule for Floater

Consider a semi-annual coupon floating rate
note, with the coupon indexed to the 6-month
interest rate.
On each coupon date, the coupon paid is based on
the previous 6-month rate.
The note pays par value at maturity.

Only the next coupon is known at the current

date. The later ones are random.

5-46

Example: Two-Year Floater

Consider a two-year floater with coupon rate set
to equal the six-month T-bill rate. The current
six-month T-bill rate is 5.54%. Suppose the
future six-month T-bill rates turn out as follows.
Find the cash flows from $100 par of the note.

5.54%

6.00%

Floater Cash Flows:

0.5
0
2.77

5.44%

6.18%

1.5

3.00

2.72

103.09

5-47

Valuation of Floater

Consider
a $100 par of a floater with coupon rate
set to equal the six-month rate and maturing at
time T. What is the price of the floater on the
coupon date before the maturity date, that is,
time T 0.5?

where is the annualized six-month rate from t0.5

to t.
5-48

Valuation of Floater (contd)

What
is the price of the floater two coupon dates
before the maturity date, that is, time T 1?

5-49

Valuation of Floater (contd)

Working backwards to the present, repeatedly
using this valuation method, proves that the
price of a floater is always equal to par on a
coupon date.
The coupon (the numerator) and interest rate (the

denominator) move together over time to make the

price (the ratio) stay constant.

A floater can be replicated by a dynamic strategy

of rolling six-month par bonds until floater
maturity, collecting the coupons along the way.
5-50

Valuation of Floater: Complications

The valuation of floater is more complicated than
presented.
If the spread is not equal to zero, the coupon rate

and the discount rate are different.

There might be restrictions imposed on the
resetting of the coupon rate.
For example, a floater may have a maximum coupon
rate called a cap or a minimum coupon rate called a
floor.

5-51

Inverse Floating Rate Notes

Unlike a floating rate note, an inverse floater is
a bond with a coupon that varies inversely with a
benchmark interest rate.
Inverse floaters come about through the
separation of fixed-rate bonds into two classes:
a floater, which moves directly with some interest
rate index, and
an inverse floater, which represents the residual
interest of the fixed-rate bond, net of the floatingrate.
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Fixed/Floater/Inverse Floaters

5-53

Fixed/Floater/Inverse Floaters
FIXED RATE BOND

The fixed rate bond can be split into a floater and an inverse
floater unevenly. 50/50 is the most popular split.
5-54

Fixed/Floater/Inverse Floaters
The sum of the face value of the floater and
inverse floater must equal the face value of the
fixed-rate bond.
The sum of the interest paid on the floater and
inverse floater must always equal the interest
paid on the fixed-rate bond.
Therefor a maximum/minimum interest rate

(cap/floor) is implicitly imposed on floater/inverse

floater.
5-55

Floater and Inverse Floater: Example

An investment banking firm purchases $100
million of a two-year 5.5% coupon bond in the
secondary market. Coupon is paid semi-annually.
The firm issues $50 million of floaters and $50
million of inverse floaters. The coupon rate on
the floater is set to equal the six-month T-bill
rate. Suppose the future six-month T-bill rates
turn out as follows.

5.54%

6.00%

Floater Cash Flows:

5.44%

6.18%
5-56

Floater and Inverse Floater: Example

What
is the cash flows to the floater and the
inverse floater?
What is the coupon rate for the inverse floater?
Answer: for the first period, the coupon rate on
the floater is 5.54%. The coupon payment is
The coupon payment from the fixed rate bond is
Therefore, the coupon payment on the inverse
floater is .
5-57

Floater and Inverse Floater: Example

(contd)
The coupon rate on the inverse floater is
thus

5-58

Repurchase Agreement (Repo)

An agreement between two parties whereby one
party sells securities to another party in return
for cash and agrees to repurchase equivalent
securities at an agreed price and on an agreed
future date.
Repos may be seen as being akin to collateralized
borrowing and lending.
Legally, however, the transaction under a repo
involves an outright sale of the securities that
passes full ownership of the securities to the
purchaser.
5-59

Repurchase Agreement (Repo)

This instrument is widely used between a central
bank and the money market as a means of
relieving short-term shortages of funds in the
money market. It thus represents an important
tool in monetary management.
For the party selling the security (and agreeing to
repurchase it in the future) it is a repo; for the
party on the other end of the transaction (buying
the security and agreeing to sell it back in the
future) it is a reverse repo agreement
5-60

Use of Repo: An Example

On August 31, 2007, the 30-year T-bond with a
coupon of 5.00% and maturing on May 15, 2037,
was quoted at a clean price of 102.50. The
general collateral repo rate for a term of one
month was 4.775%.
A bond dealer receives an order from a client to
buy this bond forward in one months time. What
is the forward price that dealer should quote?
Why? How should the dealer hedge the exposure,
assuming that the deal is done on August 31,
2007?
5-61

Use of Repo: An Example

The dealer will first compute the forward price as
follows:
Borrow cash in the repo markets for a one-month
term on August 31, 2007. (Cash borrowed is used
to buy the bond used in repo as collateral.)
Figure out how much has to be paid in the repo
markets on September 30, 2007, to retrieve the
collateral.
This is the forward price at which the dealers will
break even. Any additional profit margin would
depend on the extent of competition.
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Use of Repo: An Example

August 31, 2007: Using repo to finance the

purchase of the bond.
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Use of Repo: An Example

September 30, 2007: close the repo position.

Buy back the bond and deliver to the client.
5-64

Use of Repo: An Example

Calculation:

Break-even forward price =

5-65

End of the Notes!

5-66