Did you Know?
Bonds - Major characteristics:
Maturity and redemption
not the one you think!!!!!
The bond's maturity date refers to a future date on which the issuer pays the principal to the investor. Bond maturities usually range from one day up to 30 years or even more. But this maturity date must be seen as the last future date (except if the borrower is in default) on which the investor will receive the principal amount from to the issuer. Depending on redemption features, the real reimbursement date can be very different (much shorter). These redemption features usually give the right to the investors and/or the issuer to advance the maturity date of the bond.
Some redemption features are:
This is a provision that allows or require the issuer to repay the bond before the maturity date. The issuer will 'call' his bond if the interest rate index is lower than when he issued the bond. On the investor point of view, it means that the bond will be prepaid if the bond brings him too much interest compared to the current market conditions. If you purchase a bond with a 'call option', you have to pay less (get a premium) than without call because if the bond is prepaid, you will reinvest the money at a lower rate.
The put is a provision that gives to right to the investors to require from the issuer to redeem the bond before the maturity date. Investors usually exercise this option when the current market rates are higher so that he can reinvest his money at a higher rate. The put feature is a protection for the investor against an increase of the interest rate on the market and, consequently, should pay more (pay a premium) for a bond with a put than without.
PARTIAL PREPAYMENT (PAY DOWN).
This kind of feature is usually seen with mortgage backed securities. Without entering into details, a mortgage backed security is anything else but the securitisation of a pool of mortgage loans. In mortgage loans, you have a regular (often monthly or quarterly) payment of principal and also the ability for the borrower the prepay the loan before maturity. Mortgage backed securities prepay the principal to the investors in parallel the underlying mortgage loans. That's the reason why mortgage backed securities are traded on the basis of their 'average life'.
Mortgage backed bonds prices are more volatile than fixed rate bonds because the speed of redemption increases when the interests go down (when you have to reinvest at a lower rate) but decreases when interests go up. An increase in interest rates will increase the average life (the real maturity date) of your investment.
All the above was based on the assumption that the issuer has the financial capabilities to pay the investors. It is common sense to say that it is less dangerous to lend to the government than to a start-up company and this must be reflected in the return you get from the bond. To measure that risk, the concept of credit quality/credit rating has been introduced.
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