Repayment of Bond Principal - Maturity, Callable Bonds, Call Protection, Sinking Fund

The principal of a term bond is paid when the term ends. Term bonds have only 1 maturity.

Some bond issues have serial maturities—the bonds are the same except for different maturity dates, and bonds with longer maturities have a higher interest rate. Bonds with serial maturities are not callable. Equipment Trust Certificates are generally issued this way so that the principal remaining to be paid will have lesser value than the depreciating assets backing them up. Some municipal bonds are also issued with serial maturities.

A balloon maturity combines features of term and serial maturities. A portion of the principal, along with interest, is paid each year until the final year, when the remaining principal, or balloon, payment is made.

Callable Bonds

Some bonds are never callable: equipment trust certificates, FNMAs, and FHLBs. Most bonds, however, provide a callable provision that allows the issuer to refinance if the interest rates decline.

When interest rates rise, bond prices go down. If a company wanted to retire its debt, it could do so by buying its bonds in the open market for less money than it would have to pay when the bond matures. If a company has the free cash, it would be advantageous for it to do this. If the bond issue doesn’t have a large trading volume, the company may publish a tender offer in a major newspaper, such as the Wall Street Journal, at a slightly higher price than the current market price to motivate the bondholders to sell back the bonds to the company. The tender offer may be for all of an issue, or only part of it. If the company only wants to buy some of them back, then it will buy from those who sell first, until the company has fulfilled its goal.

When interest rates decline, the price of bonds go up. It would not be profitable for the company to buy back its bonds on the open market, because it will have to pay more than par value, the value that the company would have to pay when the bond matures. However, if the bond is callable, then the company can sell new bonds at the prevailing lower interest rate, and use that money to call back the higher interest bonds, in effect, refinancing their debt for a lower cost, which in bond parlance is known as refunding. Whether a bond is callable is stated in the indenture, and includes a schedule of when the bond can be called and at what price, specified as a percentage of par value. Generally, the sooner the bond is called, the more the company pays over par value. This call premium is to compensate the investor for losing his investment earlier than anticipated.

Call Protection

When a bond is called, it ceases to pay interest after the call date. However, a bond cannot be called until a certain amount of time has elapsed, specified in the indenture, and when it is called, usually a premium is paid—the call premium—which decreases yearly, to mollify the investor. After all, a bond will be called when interest rates have declined and bond prices have risen, a time when the bondholder of a high yielding bond is getting good interest and can sell at a high price. But this is the risk in buying high yielding, callable bonds in times of low interest rates. If the bond is called, not only do interest payments stop, but the call premium may be less than what the bond would get on the open market. Thus, before paying a premium for a bond, check the call specifics; otherwise, you can quickly lose some money.

How Bonds are Called

Bonds all have unique bond numbers. When only some of the bonds are called, bond numbers are selected randomly, and the bondholders are notified. When issuers can choose when to call a bond, that is an optional call. When the issuer provides a sinking fund to retire debt, how much and when is specified in the indenture, and thus, it is a mandatory call. Many bonds, especially municipal bonds, fund specific projects, and the interest and principal are paid from money earned by the project—for instance, the tolls collected by a bridge. If something happens to the bridge, and it is destroyed, no more money can be collected. An extraordinary call, or catastrophe call is made. Insurance covering the project pays the bondholders off.

Sinking Fund

Rather than refunding to pay back principal, some bond issuers establish a sinking fund, an escrow account, which the issuer deposits periodic payments to retire some bonds regularly. If interest rates are rising, the fund will purchase the bonds in the open market; if rates are decreasing, then the bonds will be called.

Repayment of bond Principal - Maturity, callable Bonds, Call Protection, Sinking Fund

Callable Bonds

Call Protection

How Bonds are Called

Sinking Fund

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