Extendable bonds come with an option to extend the maturity date of the original bond. The extension can be exercised either by the bond issuer, bondholder, or both, depending on the terms specified.
Extendable bonds provide flexible options to both the investor and bondholder. The arrangement can be set to exercise the extension option, once or more times after the original bond expires.
Deeper Definition
An extendable bond comes with an embedded option for the bondholder to extend the maturity of the original bond.
Practically, the option can be exercised by the bondholder or the bond issuer. The option allows flexibility in volatile interest rate markets to both parties. Bonds offer an inverse relationship with market interest rates, hence both parties will benefit from interest rate movement in opposite direction.
How Does an Extendable Bond Work?
The extension of the maturity date with the bond comes as an option. Both parties can agree on terms and conditions and the right to the extension option. The option can be exercised once the original bond reaches the expiry date. Hence, it can be used as an additional feature to the straight bond.
When companies issue bonds to raise capital from the market, they intend to issue long-term bonds. However, some investors prefer to invest in medium-term bonds that offer additional features such as an extension or put options. Extendable bonds attract such investors that hold investments if they foresee profitability with changing interest rates.
For instance, a company issues a bond with a 1.50% coupon rate and a maturity date of 10 years. The issuer also attaches an embedded feature of 5 years extension to the bondholder. By the time bond matures, the bondholder would have the opportunity to extend the bond with the same coupon rate for further 5 years. The bondholder would have the right to exercise the option or let the bond mature and recall the principal investment.
With the extension option providing further flexibility to the bondholder, the coupon rates would be lower than market rates for plain bonds. Since most of the time the option is granted to the bondholder, the interest rate risk is carried by the bond issuer. However, the price of the extendable bond will be higher than a bond without the extension feature.
For simplicity, we can assume that the total price of the extendable bond can be seen as a combination of the original straight bond plus the extension call option.
Extendable Bonds and Interest Rates
Changes in interest rates directly affect bond prices. If interest rates in the interbank markets rise, the bonds lose value and vice versa. Since investors do not see an attraction in keeping the bonds with lower coupon rates, they tend to sell the bonds and reinvest in bonds with a similar amount but with a higher yield.
On the other hand, if interest rates fall, prices of bonds go up. Hence investors look for investments in longer-term bonds with declining interest rates. An extension option works perfectly for the investors. At the time of bond maturity, if interest rates fall, investors would have the option to extend the bond and keep the original bond.
Bond issuers would keep making interest payments in the extension period. If the interest rates fall, they’ll enjoy a lower cost of borrowing. However, if the interest rates increase, they would be paying higher than the market interest rates that would increase their cost of borrowing.
Example
Suppose a company raises capital by issuing bonds worth $ 1 million with an interest rate of 1.50% and maturity of 10 years. Issuers attach an extension clause for 3 years for the bondholders.
Since the extension feature allows flexible terms for the investors, an issuer can slightly set the coupon rate lower than market rates. After ten years, the investors will have the option of extending the bond for further 5 years if it suits them. The issuers of the bond will have the option of extending the same bond with the same terms.
Advantages of Extendable Bonds
Extendable bonds provide several advantages to both parties.
- The extension feature converts short to medium-term bonds into long-term bonds without carrying excessive risks.
- Investors can maintain their lower costs of borrowings.
- Bondholders can exercise the option with favorable interest rates at maturity.
- Issuers can also exercise the extension clause if the interest rates fall by the maturity date of the original bond.
- Investors can trade extendable bonds at higher prices in the market.
Disadvantages of Extendable Bonds
Extendable bonds also come with some limitations:
- Investors receive lower coupon payments with extendable bonds.
- Bondholders cannot exercise the extension clause before the maturity of the original bond.
- Issuers may have to incur higher interest costs by the time the original bond matures.
Conclusion
An extendable bond comes with an embedded feature of an extension clause for the issuer, bondholder, or both. It gives investors further incentive to invest in bonds with lower interest rates but higher market prices. Issuers can lower the costs of borrowings with extendable bonds as well.
