1.Callable bond do have uncertain payout date but they also do have uncertain payout amount depending on the interest rate , how it is a type 2 liability then.
2. I am confused on how contingent convertible bond are type 4 but not callable bonds
The market value of the callable will move opposite to interest rates, but if it is called, the call value amount is fixed, e.g. at par, 102, 103, etc.
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are you trying to say that we have fixed coupon income and even if the bond is called we have a fixed rate at which it will be called.
My question further is for callable bond,given the above,we still have uncertainty about future income in terms of whether it will be decided coupon amounts or it would be call amount if it is called , in this sense so it does behave like type 4- uncertainty in payout. then how is it type 2
Can you explain this part
For an option-free bond, the bondholder can sell at any time prior to maturity, but the proceeds will be the PV(future CFs) at the prevailing rate, which is not known today. As rates drop, the price of an option-free bond will rise, but those with the call option have a ceiling on the proceeds, so in a sense, the amount is known. Of course, there could be multiple possible call dates
I think to distinguish the types of liabilities, you have to ask if there is a non-zero probability of the amount and/or timing being known.
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Majority of callable bonds are typically callable at par. So for $100 face value bond the callable amount is always $100. If it trades above par, the issuer will call it. If it trades at $95, it will not be called.
I’ve never seen a bond callable at “whatever the prevailing market price is”. It’s not something anyone would buy. Always known beforehand.
- Callable bonds and contingent convertible bonds are different types of liabilities, and their classification is based on different criteria.
Callable bonds are categorized as Type 2 liabilities because their payout date is uncertain. The issuer has the right to redeem the bond before its maturity date, which introduces uncertainty regarding the exact timing of the bond’s payout. However, the payout amount of a callable bond is fixed and predetermined at the time of issuance. The bondholder knows the face value and coupon payments of the bond, regardless of changes in interest rates.
On the other hand, contingent convertible bonds, also known as CoCos, are classified as Type 4 liabilities. These bonds have features that allow them to convert into equity or be written down into a different security if certain pre-defined triggers or events occur, typically related to the financial health of the issuer. The conversion or write-down features are contingent upon specific conditions being met, such as the issuer’s capital ratio falling below a predetermined threshold. The payout amount of CoCos is uncertain because it depends on these contingent events and may vary depending on the specific terms of the bond. The timing of the payout is typically fixed or certain, unlike callable bonds.
- While both callable bonds and contingent convertible bonds involve uncertainty, they are classified differently because they have distinct characteristics and risks.
Callable bonds, as mentioned earlier, have uncertain payout dates but fixed payout amounts. The main risk for bondholders is the potential early redemption, which could occur when interest rates decline, leaving investors with reinvestment risk as they have to find alternative investments with potentially lower yields. Callable bonds are primarily affected by interest rate changes.
On the other hand, contingent convertible bonds (CoCos) have uncertain payout amounts based on the occurrence of specific events or triggers. CoCos are designed to absorb losses and strengthen the capital position of the issuer during periods of financial distress. The conversion or write-down features of CoCos allow the bond to contribute to the issuer’s capital, reducing the risk of default. The main risk for CoCo bondholders is the possibility of conversion or write-down in adverse circumstances, which can result in a loss of principal or a change in the bond’s characteristics.
In summary, while both types of bonds involve uncertainty, callable bonds are classified as Type 2 liabilities due to uncertain payout dates, whereas contingent convertible bonds are classified as Type 4 liabilities due to uncertain payout amounts based on contingent events.
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It is simple. Callable bonds are less of mkt price or par value (assuming call price as par value). The payout is not uncertain.
Convertible depends on the event occuring. The event may or may not occur. It is not about amount alone but entirely the whole obligation is uncertain and hence classifying as type 4 is prudent.