"Membership has its privileges," American Express ads used to tell us. Certain bond issuers also have privileges...specifically, the privilege of calling in their bonds before the maturity date if interest rates in the market go down.
Known as callable bonds, the issuer will clearly state what the possible call dates will be and the amount of extra premium they will pay to make up for the lost interest the holder would have received if the bonds had gone to maturity. Callable bonds usually start out offering a higher interest rate than bonds of similar risk.
Example: The city of Flint, Michigan needs additional funds to continue replacing water pipes that became corroded with lead. So, they issue a $5,000 callable bond with a 6% coupon (interest payment) and a maturity date of January 1, 2028. However, there's a call date of September 30, 2022 with a call price of $5,060. Because this bond issue has a call date, the 6% interest is probably better than what is being offered by similar-risk bonds and maturity dates.
Suppose that in the summer of 2022 interest rates in the market tank, so the city of Flint decides to call in the 6% bonds and issue 4% bonds. They will pay their investors a premium of $60 as a call price per bond ($5,060 - $5,000) to help make up for missing out on the higher interest rate for four years. Flint wants to refinance their higher interest bonds for lower interest ones in order to incur less debt. Also, when interest rates go down, the price of a bond goes up, so the city can most likely issue new bonds at a lower interest rate and get a higher price.
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Finance: What are Convertible Bonds?9 Views
Finance a la shmoop what are convertible bonds? okay there's a joke about the
Inquisition in here somewhere or maybe something about Cossacks and 17th
century Russia what do you think animated musical or maybe a King Henry [King Henry VIII appears]
thing but yeah all that's different kind of conversion way more pedantically a
company might be having a hard time selling or issuing its bonds to Wall [Man with company briefcase for head meets man with Wall Street briefcase for a head]
Street in order for them to close the deal with their stock trading today at
25 bucks a share they might say well these bonds are convertible into 20 [Man with company for a head discussing bonds]
shares of our stock that is they would have a single thousand dollar unit of
that bond and it would convert into 20 shares which would then value the shares
at 50 bucks either thousand divided by 20 there's 50 it's an advanced calculus
sorry if you didn't have it which would sort of be you know the over/under price
at which bondholders would start to seriously look at converting their nice
safe bonds into those risky pesky equities well why would a company offer
convertible bonds instead of you know just vanilla bonds well if they were [Man discussing convertible bonds]
stuck paying 6% interest on just bonds but really could only afford to pay 4%
well they might get the interest rate discount by throwing in that equity
kicker in the bonds having that convertibility feature yes they would
suffer dilution at 50 bucks a share but that price is double and change where
the stocks out here so the company is probably thinking that it wouldn't mind
some dilution from these bonds being converted up there in stock price right [Arrow points to stock value mark on graph]
and remember the bonds pay the 4% interest along the way until they are
converted the moment those bonds are converted into equity well then the debt
on the balance sheet of the company and its obligation to pay that 4% yearly [Company balance sheet and interest highlighted]
interest goes mercifully away they print 20 more shares for each bond converted
and yes those shares may pay a dividend but as far as the convertible bonds go
they are thereafter converted and saved and remember Jesus Saves but Moses
invests
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