DEFINITION of 'Cushion Bond'

A type of callable bond that sells at a premium because it carries a coupon rate that is above market interest rates. A cushion bond's call feature means that it will be priced on a yield-to-call basis (meaning it can be redeemed prior to maturity), rather than on a yield-to-maturity basis; this relatively shortened maturity decreases its sensitivity to changes in interest rates. A cushion bond is so called because its resilience to interest rate fluctuations provides a cushion or a degree of protection against rate changes, especially when they are rising.

BREAKING DOWN 'Cushion Bond'

Cushion bonds may be especially suitable for conservative investors who do not wish to see too much volatility in the value of their fixed income portfolios. Such investors may be willing to sacrifice upside potential in their bond portfolio for the benefit of lower downside risk.

For other investors, the lower sensitivity of a cushion bond may be a desirable attribute when interest rates are rising, since its above-market coupon rate and call feature will diminish the impact of higher interest rates. As a result, the cushion bond's market price will decline less than other comparable bonds without these features.

When interest rates are falling, however, the cushion bond will appreciate in price to a lesser extent than other comparable bonds that are non-callable and have lower coupon rates. This may make cushion bonds less desirable to the average investor during periods of falling interest rates.

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