By Bill Broich
One of the cheapest and best long term source of funding for corporations is to issue bonds. Bonds are long term commitments for both the issuer and the buyer, or are they?
How do corporations issue bonds to benefit themselves? Can they change the rules once the bond is issued?
The answer sadly is yes.
Before we discuss how bonds favor the insurer, we need to learn an important term used in the bond world: callable. The “callable” feature means that if the bond issuer can offer the same bonds at a lower interest rate than they are currently paying, they will “call” the bonds and reissue.
Here is an example: Corporation A issues bonds to build a new factory, since it is a long term commitment the bond maturity date is 20 years. The bonds will pay an interest rate of 6% with interest due quarterly. The bond amount is $1,000.
We are investors who agree to buy the bond for $1,000 and are happy to earn interest of 6% per year. But a funny thing happens; either general interest rate will go up or down. Let’s assume that interest rates in the general financial world strengthen to 8%. Now a new bond could be purchased and an interest rate of 8% could be earned. But you have all your funds invested in the older bond earning only 6%. You are stuck and there is nothing you can do other than sell your bond (discount) for less than you paid for it. Or you are stuck holding it until maturity (20 years).
That is life and you are stuck with your earlier decision. But general interest rates could have gone lower and you could have earned a higher than market interest rate (you are earning 6%). Now the bond issuer is stuck right?
Our Corporation A issued the bond you purchased with an “Escape Hatch” which allows them to redeem your bonds early. That technicality is the callable feature, callable if it is in the best interest of the bond issuer, Corporation A.
Corporation A issues new bonds at a lower interest rate and buys back your bond, on which they were paying a higher interest rate. A true advantage for the Corporation A, a disadvantage for you — the bond buyer.
How was this advantage for Corporation A allowed to happen? Simple — you trusted Wall Street. There are numerous other advantages dreamed up by Wall Street to provide advantages to their side. Be careful and make sure you fully understand how bonds work and how their benefits can help you and how their disadvantages can damage you.