A contingency provision is a clause in a legal agreement that allows for an action if an event or circumstance occurs.
The most common contingency provisions for bonds involve the right—but not the obligation—for an issuer or the bondholders to take an action specified in an indenture.
Callable Bonds
An issuer of a callable bond has the right to redeem (or “call”) all or part of the bond prior to the specified maturity date. An issuer considering callable versus non-callable bonds usually seeks the flexibility to refinance debt if market interest rates were to fall. Fixed-price calls grant an issuer the right to buy back the bond at a predetermined price in the future.
Callable bonds typically specify a period over which the call feature cannot be used, known as a call protection period. During the call period, the period in which the call feature may be used, a schedule specifies the call price, or fixed price payable to bondholders if the issuer calls the bond.
Investors expect to be compensated on callable bonds with a higher yield versus a similar non-callable bond given the uncertain maturity and limited price appreciation, known as call risk.
Putable Bonds
A put provision gives bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates. The put price is usually the par value of the bond. Puttable bonds benefit bondholders by guaranteeing a pre-specified selling price at the redemption dates. If interest rates rise after issuance and bond prices fall, bondholders can sell or “put” the bond back to the issuer and reinvest the proceeds at higher market interest rates. The issuer will then be forced to refinance its debt earlier than planned at higher yields.
Convertible Bonds
A convertible bond is a debt instrument with a contingency provision related to the issuer’s outstanding common equity.
It grants bondholders the right to exchange the issuer’s bond for a number of its common shares in the future at an effective price per share known as the conversion price.
The conversion feature rises in value to investors as the share price appreciates. Rather than a right to retire debt early in the case of callable and putable bonds, if exercised, the convertible feature replaces debt with equity.
The conversion ratio represents the number of common shares a bond may be converted into for a specific par value:
Conversion ratio = Convertible bond par value/Conversion price.
One way to estimate the value of the conversion feature at any time is to compare the convertible bond’s price with its value if the bondholder were to convert the bonds today. This conversion value is calculated as follows:
Conversion value = Conversion ratio × Current share price.
