Lecture Note Five:

Bonds with Other Features

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

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 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: Fabozzi’s 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 bond’s
cash flows.
The traditional pricing method and yield spread analysis
however assume bond’s 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 year’s 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? (cont’d)
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 (cont’d)
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.

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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

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 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

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 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
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

Refunding benefit
= ($3/0.07) – ($100 × 1.25%)
= $42.86 – $1.25 = $41.61
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 Valuing a Callable Bond
Callable bond can be considered as having two
components: a non-callable bond and a call option.

In order to discount random cash flows, we need

discount rate for each state of nature in the future. To
price the callable bond we will use a binomial interest
rate tree model.

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 Valuing a Callable Bond (cont’d)
The construction of binomial interest rate tree will be
covered in later lecture. We take the following tree with risk-
neutral probability of 0.5 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

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 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 (cont’d)
If the bond is not called in year 1, the price of the 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 (cont’d)
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

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 Calculation (cont’d)
The price of the non-callable bond at node N, now, is

Therefore, the value of the option embedded in the

callable bond is

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 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 35 basis points.
• Note: the computation can be done using trial and error
method or solver in excel.

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 What is a Convertible Bond?
A convertible bond is a bond with an option to convert
bond into a predetermined amount of bond issuer’s
equity at certain times during its life.
• The conversion right belongs to the bondholder.

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.

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 Convertible Bond: Basics
Conversion ratio: the number of shares of common
stock that the bondholder will receive from exercising
the option of a convertible bond or an exchangeable
bond.
The conversion can be settled physically or financially.
• Physical settlement: the bondholder receives the
underlying shares from the issuer.
• Financial settlement: the bondholder receives the cash
value of the underlying shares from the issuer.

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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)

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 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

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 Premium over Straight Value
The market price of the convertible bond will never fall
below its straight value. Thus, the downside risk of
convertible risk can be 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.

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Pros and Cons of Investing in a Convertible Bond

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.
• Other disadvantages of investing in a convertible bond
may include call risk and takeover risk.

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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.

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 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
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Convertible Bond: Example (cont’d)
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. Not convert!

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Convertible Bond: Example (cont’d)
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%. 5-34
Convertible Bond: Example (cont’d)
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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 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

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 Options Approach to Valuation
An investor who purchases a non-callable /non-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

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 Options Approach to Valuation
Consider a common feature of a convertible bond: the
issuer’s 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 issuer’s 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

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 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 bondholder’s call option on
the stock and the issuer’s right to call the bonds.
• The bondholder’s 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.

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 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).

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 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 T-bill, 6-month
LIBOR), while VRNs are based on longer-term rates (1-
year T-bill, 2-year LIBOR)

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 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.

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 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.

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 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 t–0.5 to t.

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 Valuation of Floater (cont’d)
What is the price of the floater two coupon dates before
the maturity date, that is, time T – 1?

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 Valuation of Floater (cont’d)
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.

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 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.
• Capped & Floored Floater Deposit offered by HSBC:
https://www.personal.hsbc.com.hk/1/2/hk/investments/sp/ca
pped
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 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 floating-rate.

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Fixed/Floater/Inverse Floaters

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 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.
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 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.

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 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.

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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 .

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Floater and Inverse Floater: Example
(cont’d) The coupon rate on the inverse floater is thus

Coupon Rate Cash Flow

Period
Fixed Fltr Inv. Fltr Fixed Fltr Inv. Fltr
1 5.50% 5.54% 5.46% 2.75 1.385 1.365
2 5.50% 6.00% 5.00% 2.75 1.500 1.250
3 5.50% 5.44% 5.56% 2.75 1.360 1.390
4 5.50% 6.18% 4.82% 2.75 1.545 1.205
(IV) (I) (II) (III)

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 Repurchase Agreement (Repo)
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.

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 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

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 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 month’s time. What is the forward
price that the dealer should quote? Why? How should
the dealer hedge the exposure, assuming that the deal is
done on August 31, 2007?

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 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
that is 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. 5-59
 Use of Repo: An Example

Collect the
forward price

September 30, 2007: close the repo position. Buy back

the bond and deliver to the client.
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 Use of Repo: An Example
Calculation:

Break-even forward price =

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End of the Notes!

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