The contingency provisions are the embedded options that grant the issuer or the bondholder some rights. Different types of contingency provisions are:
1.1. Callable Bonds
a. The callable bonds provide benefits to the issuer, giving them the right to call the bond back or redeem the same.
b. This protects the issuer against the drops in interest rates. Thus, if the interest rates drop, the issuer can call the bonds and reissue the same at the lower rates.
c. The call options have value for the issuer. Thus, it must be compensated to the bond-holder through a higher coupon or lower price.
d. The call feature is detailed in the bond indenture, giving all information about the:
i. call-price,
ii. call dates,
iii. call premium (which reduces as time passes), and
iv. call protection period (i.e. the period in which the call feature cannot be exercised, generally a few years of issuance of bonds), also called the lockout period.
e. The call options can be in the form of a make-whole call, where the call price is the present value of all the interest and principal payments to be made, discounted at some government yield-to-maturity plus some spread. This call option is a bit costly for the issuer, but the issuer can obtain a lower coupon in return.
f. The calls can be American, European, or Bermudan.
i. The American call options are continuously callable and can be called any time during the life of the bonds.
ii. The European call option is exercisable on the call date only. There is typically one call date fixed.
iii. The Bermuda-style call option offers more than one call date, usually after the lockout period, usually on the coupon dates.
1.2. Putable Bonds
a. A putable bond is the opposite of a callable bond. It gives the bondholder an option to put the bond back to the issuer on certain dates at the specified prices.
b. The bonds with put options are of higher value to the bond-holders, therefore offers lower yield and higher prices.
c. Like calls, the puts can also be American, European, or Bermudan.
i. The American put options are continuously putable and can be exercised at any time during the life of the bonds.
ii. The European put option is exercisable on the put date only. There is typically one put date fixed.
iii. The Bermuda style put option offers more than one put date, usually after the lockout period, usually on the coupon dates.
1.3. Convertible Bonds
a. Convertible bonds are the bonds that can be converted into the common shares of the issuer.
b. In some countries, convertible bonds are not considered fixed-income security.
c. These bonds offer a call option to the bond-holders thus can be issued at a lower yield or higher price. The yields though lower, but are generally higher than the dividend yield of the shares of the company.
d. If the share prices go up the investor can get the share price, but if they go down they can redeem the bonds at their par value, at least.
e. Some of the important terminology used for the convertible shares are:
i. Conversion Price: It is the price per share at which the convertible bonds can be converted into shares.
ii. Conversion Ratio: It is the number of shares that each bond can be converted into.
iii. Conversion Value: It is also called the parity value. It is calculated by multiplying the current share price by the conversion ratio.
iv. Conversion Premium: It is the bond price minus the conversion value.
v. Conversion Parity: It is the price at which the bond-holder is indifferent towards converting it into shares. This parity is achieved when the price of the bond equals the conversion value.
When the shares are selling above parity, the bonds are said to be selling ‘off the stocks’, and there is forced conversion to avoid the overhanging convertibles.
1.4. Bonds with Warrants
a. Warrants are not the embedded options; they are rather the attached options.
b. These warrants entitle the holder to buy the underlying stock of the issuing company at an exercise Thus, the warrants are the ‘equity sweeteners’.