As a young couple looking to invest, bonds are a great way to get your feet wet. Before taking the plunge into the world of bonds, it's important to understand that the bond issuer can refund or refinance them in the event of an interest rate drop. While this action can be beneficial to the business owner, it may make your investment less attractive. Companies that issue bonds must put any refund or refinancing terms in the terms of condition, so read these carefully before investing.
A bond refund or call occurs after the issuer takes advantage of a lower interest rate. By offering a refund, the issuer buys back the bond from you, the investor, at its current rate, no matter where it is in the maturity process. This essentially puts the you at a disadvantage, since there is no way of knowing if the interest rates will drop, making the bond a risky investment. A company that wishes to have the option of refunding a bond must put it in writing before the initial sale.
The Fine Print on Refunds
Because bonds that can be refunded are considered a risky investment, they tend to have a higher yield to attract investors. Often, these bonds will have a date when the opportunity for a refund will end to protect the investor from losing out if the bond is close to maturity. In the event the bond is refunded, the issuer must pay a predetermined call price, which is usually higher than the bond’s worth. This is done to give investors some incentive to initially purchase the bond. So, if you see a bond that looks attractive, but it has a call date, look into what the refund price would be to ensure this is an investment worth your time and money.
Refinancing a bond is different from refunding one since it involves the restructuring of the bond instead of a complete reversal of funds to the investor. It’s a great way for a business to save money by taking advantage of a new interest rate while keeping you on board for the refinanced bond.
Advantage for the Investor
While a refinance is still a risky investment for you, it does offer the chance of a better return than a full refund. The bond issuer buys back the original bond and puts that money into an escrow account. In return, you will receive a new bond at the new interest rate. When the new bond matures, you'll see both the amount of the mature bond and the amount of money left over in escrow. Due to the potential large payout for your investment, most companies will refinance only during the early parts of a bond’s life.
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