Extendable reset bonds come with an option of resetting the coupon rate and extending the maturity date. Both the bond issuer and the bondholder may hold the right to extend the bond’s maturity date.
Extendable bonds come with an embedded option to extend the maturity date; hence these bonds sell at higher prices. It also means lower coupon rates for the investors. Thus, extendable bonds provide greater flexibility to investors and issuers alike.
What is an Extendable Reset Bond?
An extendable bond or note is a type of debt security that comes with an embedded option to extend its maturity date. The reset feature means the bond issuer can adjust the periodic coupon rate after a specified period.
The option to extend the maturity date can be with the bond issuer, bondholder, or both parties. First, the coupon rate is adjusted after consultation with investment banks. Usually, the bond issuers take the average of two suggestions from the investment banks to reset the coupon rate.
Extendable bonds come with an embedded option to extend the maturity date. Hence, the price of an extendable bond is the price of a non-extendable bond plus the embedded option. An embedded option with these bonds means higher pricing for these bonds. However, these bonds offer lower coupon rates than other types of bonds.
How Does an Extendable Reset Bond Work?
An extendable reset bond comes with additional features of coupon rate resetting and maturity date extension. A bond issuer can issue a bond that offers an embedded option to extend or defer the repayment of the principal amount.
Investors receive regular coupon payments until the specified period. The reset feature means both parties can agree to reset the interest rate. The interest rate is reset to keep the bond price above par value. It means the adjustment is made to justify the margin required for the bond to trade above par value.
Both parties can agree to reset the interest rate but it is often calculated as the average of the suggested rates from investment banks. For instance, if the current interest rate of the bond is LIBOR + 1.25, it can be reset to LIBOR + 1.50 after consulting investment banks.
The interest rate reset and the maturity date extension come as embedded options. Hence, neither of these features becomes an obligation to either party. However, these features mean the bond trades at a higher price than similar other bonds without the extension feature.
Special Considerations with Extendable Reset Bonds
The option to extend the bond’s maturity date can be given to the bond issuer, the bondholder, or both parties. When the bond issuer holds the option of extending the maturity date, the bond is traded as a put option. Conversely, if the bondholder holds the bond maturity extension feature, it will be priced as a call option.
Both parties can mutually agree to extend the maturity date as well. Also, the extension of the maturity date can be offered more than once. For example, if the original bond is issued with a shorter maturity, it can be extended more than once.
We know the inverse relationship between the coupon rate and bond prices. When interest rates increase, the value of the short-term bonds falls. But the value of the extendable bonds does not fall as much due to the embedded option of maturity date extension.
Example
Suppose a company ABC issues an extendable reset bond worth $ 2 million. The coupon rate is set at LIBOR + 2%. The bond comes with a maturity of three years and embedded options of extension and interest rate reset.
The investors would keep receiving the coupon payments until three years. At maturity, both parties can agree to extend the maturity period, say to five years instead of three. If agreed, both parties can reset the coupon rate as well. Say, the new bond coupon rate is set at LIBOR + 1.5%.
Advantages
Extendable reset bonds offer several advantages to investors and issuers.
- Investors and issuers can minimize the interest rate risks.
- Investors can trade these bonds at higher prices.
- Issuers can take advantage of lower interest rates and can extend the maturity without taking the risks of long-term debt.
Disadvantages
Extendable reset bonds also offer some limitations to both parties.
- Investors receive lower coupon payments.
- Both parties may not find it suitable to extend the maturity date due to unfavorable interest rates.
- The issuer may have to issue new bonds with similar features to replace the older bonds.
Final Thoughts
Extendable reset bonds offer greater flexibility to bond issuers and investors alike. Both parties or one of them can agree to extend the maturity date. Also, both parties can agree to reset the coupon rate after a specified period.