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An Introduction to the Bond Markets by Patrick J. Brown

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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 ...

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