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Advanced refunded bonds, or pre-refunded bonds, are usually municipal bonds. New bonds, called refunding bonds, are issued to buy Treasuries at a higher interest than the municipal bonds, which are then used to retire the debt of the original bond issue as they mature. Thus, the pre-refunded bonds are no longer backed by the pledge of the municipal issuer. However, because the bonds are now backed by Treasuries, they are considered risk-free.
Catastrophe bonds (frequently shortened to cats), first marketed in the 1990's in response to Hurricane Andrew and the earthquake in Northridge, California, are issued by insurance companies to cover catastrophes such as windstorms in Europe and earthquakes in Japan, but the majority cover hurricanes in the United States. It is a means by which insurance companies can transfer their risk. Reinsurance is not readily available for such disasters, and, in the event of a disaster, insurance companies get their money faster from catastrophe bonds than they do from reinsurance. Another advantage of bonds over reinsurance is that the issuer can get coverage over several years.
The risks of catastrophe bonds are hard to assess because their ratings are often based on a model portfolio rather than actual risks, which, in any case, is very difficult to forecast.
Catastrophe bonds are attractive to investors because, since it is possible to lose the entire principal from a disaster, they pay very high yields, and they don�t correlate with stocks or even with other bonds, thereby providing diversification.
Some municipal and corporate bonds have a put option, stated in the indenture, that allows the investor to require the issuer to buy back the bond at par value before the maturity date, which makes the bonds more attractive to investors in times when interest rates may rise, forcing the price of bonds down, or when the credit rating of the company or municipality deteriorates, causing the price of the bonds in the secondary market to decline.
Convertible bonds, usually debentures, can be converted into common stock of the corporate issuer at the discretion of the investor. Either the number of shares or the share price is specified in the indenture. The number of shares of stock that each bond can be converted to is known as the conversion ratio. Thus, a bond that can be converted into 10 shares of stock has a conversion ratio of 10 to 1. If the share price is specified in the indenture instead of number of shares, then the conversion ratio can be found by dividing the par value of the bond—$1,000—by the share price. Thus, if a share price of $20 is specified, then the conversion ratio is $1,000/$20 = 50 shares.
Some bonds specify different conversion ratios, or different conversion prices, for different time periods. For instance, the indenture may say that in the first 10 years, the bond may be converted to 20 shares, and after that, they may be converted to 40 shares. There is also an anti-dilutive provision where the conversion ratio or conversion price is changed to reflect any stock splits or stock dividends.
The convertibility factor, like many special bond features, lowers the interest rate that the corporation would otherwise have to pay without this feature, and it appeals to investors who want current income, but would like to take advantage of any growth in the corporation.
Because convertible bonds are callable, the conversion can be forced by the company if bond prices drop. This eliminates debt and interest payments for the company.
The advantages of convertible bonds to an investor is that it offers appreciation potential if the company does well, and its stock rises; but, if the company suffers, and the stock price declines, the investor can still keep the bond as a bond, and collect interest and principal, or sell it, based on the interest that it pays. If the company ever goes bankrupt, the bondholder will have superior claims over any stockholder.
The disadvantages include a lower interest rate, and the possibility that the bond will be called prior to conversion, or even before when it can be converted, since some bonds restrict conversions to certain time frames.
Conversion parity is a term used to describe the relationship of the stock price, multiplied by the conversion factor, to the bond price. For instance, if the bond is currently selling for $1,200 and can be converted into 10 shares of stock, and if the current stock price is $120, then the stock price and bond price are at parity. If the stock is selling for less than $120, then it is selling below parity, and if it is selling for more than $120, then the stock is selling above parity. Usually, the bond price is higher than the parity price.
A stock selling above parity creates an arbitrage opportunity, which is the buying and selling of the same or derived securities to profit from a price discrepancy among the different securities. In this case, if the bond is selling for less than the stock multiplied by the conversion factor, then an arbitrageur can make money immediately by selling the stock short, and buying the bond. The stock is sold short because the conversion takes time, and if the arbitrageur waited, the price of the stock might decline. Example: a convertible bond that can be converted to 10 shares is selling for $1,020, but the current stock price is $120. Thus, selling short 10 shares of the stock would yield $1,200, and buying the bond to cover the short would yield a net profit of $180.
Sometimes a corporation can impel a bondholder to convert his bond into stocks. If the bond is trading at a premium, above the call price, then the corporation can call the bond at a lower price. However, if the converted stock is worth more than the call price, then it makes sense to convert the bond to stock. Another situation that can cause a bondholder to convert is if the company raises the dividend on the stock, such that the total dividend of the converted shares is greater than the interest paid on the bond.
Shariah is the law of Islam and it bans usury and interest payments�consequently, it also bans bonds. So that Muslim countries can benefit from international investment, and so international investors can invest in projects in Muslim countries, variations of the typical bond have been financially engineered to work somewhat like bonds, but still be compliant with Shariah—thus, they are called Islamic bonds.
One such structured product is the lease-back, or ijarah, structure. If a company wanted to raise money to build a plant, for instance, using this method, it would set up a special entity specifically for this project that would buy the plant. Investors would lend money to the special entity, in return for lease payments, in lieu of interest, for the term of the deal. At the end of the term, the principal is returned to investors, and the project becomes the property of the company.
Another way to avoid paying interest, at least in name, is to form a joint venture called a musharakah. The joint venture partners buy Islamic bonds and receive a percentage of profits over the term of the loan.
Malaysia has used the deferred payment sale principle of bai' bithaman ajil. A bank buys an asset on behalf of a customer, then sells it back later for a profit. However, bai' bithaman ajil, is not acceptable to the Middle East, which has a different interpretation of Shariah, so Malaysia has been promoting financial structures that are globally compliant and can be included in the global Shariah stock indexes. Standardization also helps to reduce the cost of developing and marketing Islamic bonds.
To gauge the safety of Islamic bonds, the Islamic International Rating Agency has developed the credit-rating Shariah Quality Ratings.
Bond Yields, Credit Risk, Taxable Equivalent Yield (TEY)
Special Bonds - Advanced Refunded Bonds, Put Bonds, Convertible Bonds
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