Other Types of Bonds

Many bonds have unusual or exotic features. So-called disaster bonds provide an interesting example. In 1996, USAA, a big seller of car and home insurance based in San Antonio, announced plans to issue $500 million in "act of God" bonds. The way these work is that USAA will pay interest and principal in the usual way unless it has to cover more than $1 billion in hurricane claims from a single storm over any single one-year period. If this happens, investors stand to lose both principal and interest.

A similar issue was being planned by the proposed California Earthquake Authority, a public agency whose purpose would be to alleviate a growing home insurance availability crunch in the state. The issue, expected to be about $3.35 billion, would have a 10-year maturity, and investors would risk interest paid in the first 4 years in the event of a catastrophic earthquake.

As these examples illustrate, bond features are really only limited by the imaginations of the parties involved. Unfortunately, there are far too many variations for us to cover in detail here. We therefore close out this discussion by mentioning only a few of the more common types.

Income bonds are similar to conventional bonds, except that coupon payments are dependent on company income. Specifically, coupons are paid to bondholders only if the firm's income is sufficient. This would appear to be an attractive feature, but income bonds are not very common.

A convertible bond can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option. Convertibles are relatively common, but the number has been decreasing in recent years.

A put bond allows the holder to force the issuer to buy the bond back at a stated price. For example, International Paper Co. has bonds outstanding that allow the holder to force International Paper to buy the bonds back at 100 percent of face value given that certain "risk" events happen. One such event is a change in credit rating from investment grade to lower than investment grade by Moody's or S&P. The put feature is therefore just the reverse of the call provision and is a relatively new development.

A given bond may have many unusual features. To give just one example, Merrill Lynch created a very popular bond called a liquid yield option note, or LYON ("lion"). A LYON is the "kitchen sink" of bonds: a callable, puttable, convertible, zero coupon, subordinated note. Valuing a bond of this sort can be quite complex.

Borrowing Basics

Borrowing Basics

Some small business persons cannot understand why a lending institution refused to lend them money. Others have no trouble getting funds, but they are surprised to find strings attached to their loans.

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