"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.
Related or Semi-related Video
Finance: What is Busted Convertible?14 Views
Finance a la shmoop..what is a busted convertible?
well techno growth forever biotechs swore to its customers that upon death they [Mans head enters into a glass jar]
could sever their heads freeze them and in 40 years they would have technology
to have them reborn into a really cool robot body and yeah kim kardashian model
was a huge huge hit we cannot lie.... The company stocks zoomed to a hundred
dollars a share and management needed cash to open offices in China Latin [Cash travels around the world]
America and Africa but they didn't want to suffer dilution by just selling
equity or part ownership in themselves to the street at least not at the
hundred dollar share price they really just wanted to borrow money [Cash and an IOU note appears on a table]
to fund these new offices because well they thought their stock would easily
get to $250 a share in the next few years
tons of people out there who wanted to you know live forever
you know like fame.....nevermind their bankers were nervous about how
investors would react to just a straight bond which carried 8% interest so
instead they kind of compromised by doing a convertible preferred stock [Men give handshake]
offering they sold preferred stock to the street that carried just 3% interest
but those preferred shares were convertible into common stock at a
hundred seventy five bucks a share so the owners of the preferred would keep [Stock value of biotech company rises]
clipping their three percent coupons until one day the stock hit a hundred
seventy five bucks or better well and then they could participate in the
[Man hits a baseball] upside if the stock really was a homerun but sadly as many things do in shmoop
video....Test came back from the early decapitating trials and well they were
oh so not good legions of zombies began to roam the streets and while consumers [Zombies walking along the streets]
just didn't want to go there they'd rather truly rest in peace so the stock
cratered down to $20 a share where it would sit for all eternity in what is
called a busted convertible and took us a while to get there but we got
there the convertible preferred would pay 3% a year in interest as it always [Preferred stock with 3% interest sticker]
had and a convertible stock is so far below the conversion price of $175 well,
investors assume it will never convert the investment case views
the convert solely as a preferred or kind of like a bond offering against
competitive bond interest rates so yeah that's a busted convertible although so
is this they really never should have given robot Kim K a driver's license [Robot Kim Kardashian beside an upside down, crashed car]
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