By Tim McMahon, editor
What Are Structured Bonds?
First let’s look at what makes up a bond. A bond is a form of debt where a company borrows money from investors and has a certain expiration date called a “Maturity Date”. The interest rate that the company pays is called the “coupon rate.” One advantage of a bond over a stock is that a bond is a debt so bondholders are “creditors”.
In the event of corporate bankruptcy bondholders go to the head of the line while shareholders as owners go to the back of the line and only get whatever is left over (if anything) once all the creditors (including bond holders) are satisfied.
In an effort to lower the interest rate they had to pay to investors companies started offering “convertible bonds.” Thus a convertible bond has all the security benefits of a bond with some of the upside potential of stocks.
A convertible bond has the option to be able to be converted into stock if the price of the stock rises high enough. In this way, investors were not only lenders to the company but could also participate in the growth of the company as shareholders. In exchange for this added potential gain the bondholders were given a lower interest rate, i.e. the “Coupon rate” is lower on a convertible bond than on a similar standard bond.
Structured bonds are based on the idea of convertible bonds. In an effort to add even more flexibility and additional features including higher yields, lower risk or a variety of other features, investment banks started ‘slicing and dicing’ traditional bonds in a variety of ways creating derivatives called structured bonds.
Two Forms of Structured Bonds
There are two basic forms of structured bonds the first is called an Extendible Structured bond has the option for a holder to extend its maturity date by adding additional years. This type of bond is similar to a portfolio of a straight, shorter-term bonds with the added bonus of a “call option” giving the holder the right but not the obligation to extend the bond to a longer-term bond, if the terms are in his favor. In other words, if interest rates fall the holder has the option to hang on to his higher yielding bond for a few more years.
A stepped up bond pays one interest rate initially and a higher rate after a period of time. In other words, it is similar to an adjustable rate mortgage. Except that you as the bondholder are receiving the interest rather than paying it. So for example, the bond may pay 5% for the first three years and 7% for the remaining years.
Structured Bond Advantages
- Bonds can be structured to provide special features tailored to your specific needs due to their flexibility.
- Structured Bonds can protect against loss of principal during market downturns because they are bonds rather than stocks.
- Bonds can provide higher yields (income) than stocks.
- Bonds can be structured to provide income and capital gains.
- Structured bonds are fairly liquid, based on the current market value which may be more, or less than what you paid.
- If held to maturity you know exactly what bonds will be worth.
- It is possible to adjust the bond structure to meet specific requirements both of prudent savers or more speculative investors and to capture a certain expected market trend.
- Bonds are safer than stocks because bondholders are creditors and therefore ahead of stock holders.
Disadvantages of Structured Bonds
- If you have to sell a structured bond before maturity you may lose money.
- Structured Bonds are not designed for short term holdings.
- If the issuing company goes bankrupt, although you are in line ahead of shareholders, you could still lose all or a portion of your investment, depending on how many other creditors there are and the status of the assets held by the company.
- Structured bonds can have higher fees than regular bonds due to the complex nature of their creation and the higher fees collected by the investment banks that created them.
Are Structured Bonds for You?
If you are looking for higher income or to meet a specific financial need there is probably a structured bond that has been created to fit that need. The key is to look at how its terms compare to your specific needs.
For more info see Structured Product