An extendable or retractable bond offers investors the opportunity to take advantage of movements in interest rates. However, the extension or retraction feature means that the price of these bonds is higher and the interest rate lower than other similar term bonds.
What is an Extendable or Retractable Bond?
An extendable or retractable bond has more than one maturity date. An extendable bond gives the holder, and/or the user, the right to extend the initial maturity to a longer maturity date. A retractable bond gives its holder the right to advance the return of principal to an earlier date than the original maturity. Investors use extendable and retractable bonds to modify the terms of their portfolio to take advantage of movements in interest rates. The characteristics of these bonds are a combination of their underlying terms. When interest rates are rising, extendable and retractable bonds act like bonds with shorter terms; when interest rates fall, they act like bonds with longer terms.
Differences Between an Extendable or Retractable Bond
When considering the differences between an extendable or retractable bond, the most important aspect to consider is maturity. An extendable bond gives its holder the right to “extend” its initial maturity at a specific date or dates. The investor initially purchases a shorter-term bond combined with the right to extend its term to a longer maturity date. An investor purchases an extendible bond to have the ability to take advantage of potentially falling interest rates without assuming the risk of a long-term bond. As interest rates fall, the price of a shorter-term bond rises less than the price of a longer term bond. This means the extendable bond begins to behave or “trade” as though it were a longer-term bond. On the other hand, if interest rates rose, it would behave like a shorter-term bond. Conversely, with a retractable bond, an investor owns a longer-term bond with the right to “retract” it at a specific date. For the investor, as interest rates rise the bond falls in price. Once its price is low enough, it will begin to behave as a short-term bond and its price fall will be much less than that of a normal long-term bond. At worst, the investor can retract it at the retraction date and receive the par amount in return, which they can then reinvest.
Pricing an Extendable or Retractable Bond
Usually, the extension or retraction feature means that the price of an extendable or retractable bond is higher and the interest rate lower than other similar term bonds. The motivation of the issuer is obvious: having to pay a lower interest rate than would otherwise be the case. The investor gains the potential upside of a longer-term bond with the price risk of a shorter-term bond. With the development of options and swap markets, these bonds are priced using option pricing techniques. These view extendable/retractable bonds as a combination of a normal bond and a “call option” (extendable) or “put option” (retractable).
Are Extendable and Retractable Bonds Attractive?
If an investor constantly invested in an extendable or retractable bond, the net result would be a lower return due to the lower yield of these bonds compared to normal bonds of the same term. An investor unable to accept the price risk of longer-term bonds would be better off with an extendable/retractable bond than with exclusively shorter-term bonds, as this would generate a higher yield and reduce the income risk of the portfolio. Investors with an interest rate view who are not willing to accept the risk of being “out of the market” should use these bonds to protect their portfolios.