Bonds are issued for the purpose of raising funds. This chapter concentrates on bonds, particularly those with embedded options. It ends with a discussion of key rate durations.

Introduction

A bond can be secured or unsecured. A secured issue is one for which the issuer pledges specific assets that may be used to pay bondholders if the firm defaults on its payments. Many bond issues are unsecured, however, with no specific assets acting as collateral. Long-term unsecured issues are called debentures, whereas short-term unsecured issues such as commercial paper are referred to as notes.

It is common for a bond issue to include in the indenture provisions that give either the bondholder and/or the issuer an option to take certain actions against the other party. The bond indenture is the master loan agreement between the issuer and the investor. A common type of embedded option in a bond is a call feature, which grants the issuer the right to retire the debt, fully or partially, before the maturity date. An issue with a put provision, as another example, grants the bondholder the right to sell the issue back to the issuer. Here the advantage to the investor is that if interest rates rise after the issue date, reducing the bond's price, the investor can force the issuer to redeem the bond at, say, par value. A convertible bond (CB) is an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock.