We have so far looked at two forms of duration: Macaulay and modified. There are a couple of more that deserve attention. But first we need to explain the concept of an embedded option.
Embedded options are “kickers” that provide a bond issuer or bondholder with the possibility of taking some action (with respect to another party) that is not available in “straight vanilla” bonds. There are four common types:
Callable – allows the bond issuer to force the redemption of bonds before maturation. The issuer has a date-limited (the call date) opportunity, but not an obligation, to redeem the bond at a predetermined price (the call price). This embedded call lowers the value of the bond to the bondholder, because of the possibility of a truncated set of cash flows. Therefore the issuer must normally issue the bonds with an elevated interest rate (equivalently, a lower price) to compensate the buyer for call risk.
The embedded call option can be valuable to an issuer if interest rates decline between the issue date and the call date – the issuer can call the bonds and issue new ones at a lower coupon. The call price is usually above the issue price; the differential is called the call premium. Nonetheless, if interest rates decline enough, the call price will be less than the bond’s current market price, and is thus a bargain for the issuer at the expense of the holder.
The price of a callable bond is equal to the value of the straight bond plus the value of the option. This causes the yield on a callable bond to exceed that of the corresponding straight bond. Bonds can be issued with a multi-date call schedule, where portions of the issue can be redeemed at any of several different call dates.
Puttable – allows the bondholder to demand early repayment on one or more specified put dates. It is the equivalent of a straight bond and a put option, and confers additional value to the bond holder. Issuers can sell puttable bonds at a premium relative to the equivalent straight bond because of the put’s additional value to the bondholder. Bondholders are likely to put the bond to the issuer if interest rates have risen since the issue date, because the equivalent straight bond’s market price will have declined under this circumstance.
Purchasers of puttable bonds will see their put’s value decrease if the issuer is bankrupt on the put date. Bankruptcy will not necessarily render the embedded put’s value worthless, as it confers a higher claim by the puttable bond on assets relative to straight bonds.
A bond may be both puttable and callable; the issue price of the bond is influenced by both options.
Convertible – a bond that can convert into a predetermined number (expressed by the conversion ratio) of an issuer’s shares at a predetermined conversion price. The price of this hybrid security is thus correlated, within limits, to the price movement of the underlying shares. It is equivalent to holding a straight bond plus a call option on the underlying stock, except that executing the call option requires surrender of the convertible bonds. A large price decline of the underlying stock creates a “broken convert”; the floor on the convertible bond’s price is the price of the equivalent straight bond, the call premium having disappeared. Thus the bondholder has upside potential with limited downside risk. This mixture benefits the bondholder and thus allows bond issuers to sell convertible bonds at a premium to the equivalent straight bond. This is the same as saying that the issuer can provide a lower coupon rate. Convertible bonds are dilutive – they have the potential to increase the number of issued shares and thus may reduce equity per share.
We’ll have a lot more to say about convertible bonds in a future article.
Exchangeable – similar to a convertible bond, except the underlying shares are for a company other than the issuer.
Armed with this information, we can next time resume our review of the different varieties of bond duration.
SEC Asking Hedge Funds for Comments on Regulations
July 29th, 2010The Securities and Exchange Commission has asked hedge funds for comments on regulations. The SEC wants to get a sense of what hedge fund managers think about the provisions in the Dodd-Frank financial reform bill.
SEC Chairman Mary Schapiro said in a speech Thursday to the U.S. Chamber of Commerce that hedge funds “have flown under the regulatory radar for far too long.”
“The lack of a comprehensive database for private funds has made it virtually impossible to monitor them for systemic risk and investor protection concerns,” she said.
Last week, however, in Congressional testimony, Schapiro said she wasn’t sure if hedge fund firms posed a systemic risk to financial systems.
Schapiro also said in her speech that the SEC had been working closely with the U.K.’s Financial Services Authority on hedge fund reporting requirements.
Whatever the position the U.S. regulator may take on the systemic risk issue, the public is being encouraged to go to the SEC Web site and fill out a comment form even before the official regulation comment periods are opened.
The following is an excerpt from the beginning of the SEC announcement:
“The Dodd-Frank Wall Street Reform and Consumer Protection Act includes provisions that require the SEC to undertake various initiatives, including rulemaking and studies touching on many areas of financial regulation.
Members of the public interested in making their views known on these matters, even before official comment periods may be opened, are invited to submit those views via the email addresses below. While the Commission has responsibilities under other provisions of the Act, the list below covers major regulatory topics and other more immediate matters. The Commission may add additional email addresses in the future.
Members of the public who wish to submit official comments on particular rulemaking initiatives should submit comments during the official comment period that starts with the notice of the initiative published in the Federal Register.
The Commission will post all submissions on this page of the Commission’s Internet Web site. All submissions received will be posted without change; we do not edit personal identifying information from submissions. You should only make submissions that you wish to make available publicly.”
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