Extendible and retractable bonds have more than one maturity date. An extendible bond gives its holder 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 extendible/retractable bonds to modify the term 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, extendible/retractable bonds act like bonds with their shorter terms When interest rates fall, they act like bonds with their longer terms.
Extendible/retractable bonds are created by issuers because they pay a lower interest rate on these bonds than would otherwise be case or they "sweeten" the issue with this feature, making the issue easier to sell. Buyers are attracted to these bonds because the extension or retraction option is attractive to them.
Extendible Bonds
An extendible 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 extendible bond begins to behave or "trade" as a longer term bond. On the other hand, if interest rates rose, the extendible bond would behave as a shorter term bond.
Retractable Bonds
With a retractable bond, an investor owns a longer term bond with the right to "retract" it at a specific date. Consider an investor that believes that interest rates will rise and bond prices will fall, but is not willing or able to sell out of bonds completely. This investor can buy a longer term retractable bond which behaves initially as a similar term long term bond. 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 a normal long term bond. At worst, the investor can retract it at the retraction date and receive the par amount back to reinvest.
Pricing Extendible/Retractable Bonds
Usually, the extension or retraction feature means that the price of an extendible/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's motivation comes from the "defensive" feature of these bonds. The investor gains the potential upside of a longer term bond with the price risk of a shorter term bond. Looking at it another way, the investor can lock in a longer term interest rate with the option to shorten at his or her discretion.
Originally, these bonds were created as "sweeteners" as a way to sell bonds more easily. The market conditions were not conducive to issuing longer term bonds or the issuer wanted a lower interest rate than was available at that time. Adding the extension or retraction feature made it easier to sell the issue or cheaper for the issuer. At that time, the "rule of thumb" was that these bonds should be issued .2% less in yield than a normal bond of the same issuer.
More recently, with the development of options and swap markets, these bonds are priced using option pricing techniques. These view extendible and retractable bonds as a combination of a normal bond and a "call option" (extendible) or "put option" (retractable). "Option Adjusted Spread" (OAS) analysis uses statistical "decision trees" to assess the worth of these options given historical patterns of interest rate movements.
Are Extendible/Retractable Bonds Attractive?
As with anything, you get what you pay for with extendible/retractable bonds. If an investor constantly invested in these bonds, 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 in extendible/retractable bonds 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 but not willing to accept the risk of being "out of the market" should use these bonds to protect their portfolios.
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