Advanced Concepts and Unusual Features of Bonds
Bonds often have special characteristics that affect the desirability of the bond and/or its purchase price. This section will review some of the unusual features that bonds may carry.
When a bond is issued, it will be either callable or non-callable. A callable bond is one in which the company can require the bondholder to sell the bond back to the company. Buying back outstanding bonds is called "redeeming" or "calling". When issued, the bond will explain when it can be redeemed and what the price will be. In most cases, the price will be slightly above the par value for the bond and will increase the earlier the bond is called.
A company will often call a bond if it is paying a higher coupon than the current market interest rates. Basically, the company can reissue the same bonds at a lower interest rate, saving them some amount on all the coupon payments; this process is called "refunding." Unfortunately, these are also the same circumstances in which the bonds have the highest price - interest rates have decreased since the bonds were issued, increasing the price. In many cases, the company will have the right to call the bonds at a lower price than the market price. If your bond is called, you will be notified by mail and have no choice in the matter. The bond will stop paying interest shortly after the bond is called, so there is no reason to hold on to it. Companies also typically advertise in major financial publications to notify bondholders. Generally, callable bonds will carry something called call protection. This means that there is some period of time during which the bond cannot be called.
Zero Coupon Bonds
Some bonds, called zero coupon bonds, don't pay out any interest prior to maturity. These bonds are sold at a deep discount because all of the value from the bond occurs at maturity when the principal is returned to the bondholder along with interest. These bonds are also known as "zeros." One type of zero-coupon bond is a "strip." The interest payments are separated from a bond's principal and multiple zero coupon securities are created, one representing the principal amount and one representing each coupon payment. A problem with zero-coupon bonds is that, even though you do not receive any interest payments during the time you hold the bond, you are still responsible for paying taxes on the suggested interest you are earning. The taxes are based on the appreciation of the bond's market value, which will increase consistently as it approaches maturity. Zeros are also more volatile than bonds that have regular interest payments. The main benefit of zero coupon bonds is if you are saving for a specific event that will occur at a specific time, such as paying for college. You can purchase the zero coupon bonds to mature just before you will be needing the money.
Secured vs. Unsecured Bonds
Bonds can either be secured by some sort of collateral or unsecured. Unsecured bonds, called debentures, are considered to be riskier than secured bonds because they are simply backed by the issuer's word that it will repay the bonds. Secured bonds are backed by some goods that can be sold by the issuer to raise money to pay off the debt in the event of default. Corporate and municipal bonds can be secured or unsecured, while bonds issued by the federal government are unsecured (but, of course, the government can simply print money to pay off its debts). The most common form of secured bonds are mortgage bonds. These bonds are backed by real estate or physical equipment that can be liquidated. These are thought to be high-grade, safe investments. Other bonds are secured by the revenues created by projects. If an issuer in default has both secured and unsecured bonds outstanding, secured bondholders are paid off first, then unsecured bondholders. Naturally, because unsecured bonds carry greater risk than secured bonds, they usually pay higher yields.
Tax Deferred Bonds
Some bonds are free from federal taxes while others allow you to defer those taxes until maturity . When evaluating the value of a bond, the tax considerations can play a major role in determining whether the investment is appealing or not. Find out your tax options on any bond you are considering.
The opposite of a callable bond, a bond with a put provision allows the bondholder to redeem the bond at par value with the issuer at a specified point before maturity. Investors might choose to do this if interest rates increase after the bond was issued. The bond will restrict the dates when this can be done. These bonds are quite rare.