Definition
A puttable bond gives bondholders the right to sell the bond back to the issuer before maturity, usually at its face value. This protects investors if interest rates rise or the company's credit quality declines.
Example
You own a 5-year bond that is puttable after 3 years. If interest rates rise and the bond's market value drops to $920, you can exercise the put option to sell it back to the issuer for its full $1,000 face value, thus avoiding a loss.
Interview Q / Model Answer
Q: Why would an investor exercise a put option?
A: To exit the bond early and get their principal back if interest rates have risen (allowing them to reinvest at a better rate) or if the issuer's credit risk has increased.
Definition
A callable bond gives the issuer the right to redeem the bond from investors before its maturity date, typically at a fixed price. Companies do this to refinance their debt at a lower interest rate.
Impact on Bondholders
Investors lose out on future interest payments and are forced to reinvest their capital at what are likely lower prevailing interest rates. This is known as reinvestment risk.
Interview Q / Model Answer
Q: What is the main risk of callable bonds for investors?
A: Reinvestment risk. The issuer is most likely to call the bond when interest rates have fallen, meaning the investor gets their principal back at a time when it's difficult to find a new investment with a comparable yield.
Definition
A bond default occurs when the issuer fails to make its scheduled interest (coupon) or principal payments on time. It is a clear signal of financial distress.
Impact on Bondholders
The bond's market price collapses, and investors may lose a significant portion or all of their investment. Their ability to recover any money depends on their position in the creditor hierarchy and the proceeds from the company's liquidation or restructuring.
Interview Q / Model Answer
Q: What happens to bondholders in case of default?
A: They become creditors in a bankruptcy or restructuring process. They will typically recover a fraction of their original investment, with the exact amount (the "recovery rate") depending on the company's remaining assets and the bond's seniority.
Definition
A convertible bond gives the bondholder the option to convert their debt instrument into a predetermined number of the issuing company's equity shares.
Example
You hold a $1,000 bond convertible into 20 shares (a conversion price of $50/share). If the company's stock price rises to $70, you can convert your bond into shares worth 20 × $70 = $1,400, realizing a $400 profit.
Interview Q / Model Answer
Q: Why do companies issue convertible bonds?
A: They can typically offer a lower coupon rate than traditional bonds, saving on interest costs. It also offers a way to raise capital that may eventually convert to equity, potentially delaying shareholder dilution.
Definition
An offer by the issuer to buy back its bonds from investors before maturity, often at a premium to the current market price. This is a voluntary action for bondholders.
Impact on Bondholders
It provides an opportunity to exit the investment early and at an attractive price (a premium). The trade-off is losing out on future coupon payments.
Interview Q / Model Answer
Q: Why would a company launch a bond tender offer?
A: To proactively reduce its debt load, especially if it has excess cash. It can also be part of a larger strategy to refinance debt or clean up its balance sheet.
Definition
A debt exchange is an offer where bondholders can swap their existing bonds for a new set of bonds, often with different terms (e.g., a longer maturity date or a different coupon rate).
Impact on Bondholders
This is often done during times of financial stress for the issuer. While the new terms may be less favorable (e.g., lower interest), accepting the exchange can be better than risking a total loss in a potential default. It increases the certainty of repayment.
Interview Q / Model Answer
Q: Why do bondholders accept a debt exchange even if terms are less favorable?
A: Because a reduced but certain return is often preferable to the risk of a complete loss in a bankruptcy. It's a way for distressed companies and their creditors to find a manageable path forward.
| Corporate Action | Who Has the Right | Purpose | Impact on Bondholders |
|---|---|---|---|
| Puttable Bond Redemption | Bondholder | Early exit, reduce risk | Get principal back before maturity |
| Callable Bond Redemption | Issuer | Reduce interest cost | Lose future coupons, reinvest risk |
| Bond Default | – | Occurs if issuer can’t pay | Possible loss, recovery via liquidation |
| Bond Conversion | Bondholder | Convert debt to equity | Gain from share price rise, lose fixed income |
| Tender Offer for Bonds | Issuer | Retire debt early | Receive premium to market price |
| Debt Exchange | Issuer (offer), Bondholder (choice) | Extend maturity / restructure debt | Lower risk but possibly worse terms |