What is a Bunny Bond
A bunny bond is a type of bond that offers investors the option to reinvest coupon payments into additional bonds with the same coupon and maturity. This type of bond is also known as multiplier bond or guaranteed coupon reinvestment bond.
BREAKING DOWN Bunny Bond
A bunny bond essentially provides investors with a way to recycle and transition dividend payments as a mean of securing another investment. The initial bond agreement includes a clause that gives the bondholder the option, if they should choose to exercise it, to reinvest their coupon payments. This is an attractive provision for investors, as it gives them a sort of safety net or backup plan that can offer a valuable recourse if they face the possibility of taking a loss in the form of a lower interest rate.
This potential loss represents what is known as reinvestment risk. This is the possibility that a bond’s subsequent future coupons will not be reinvested at the interest rate in effect when the bond was originally purchased. If interest rates decline, that would mean a downgrade when the reinvestment occurs. This reinvestment risk will be more of a factor when interest rates are going down.
Bunny Bonds and Reinvestment Risk
Bunny bonds are an effective way to protect against reinvestment risk, which arises from the possibility that interest rates will drop in the future. This reinvestment risk will have an impact on the bond’s yield to maturity, since this is calculated based on the assumption that future coupon payments will be reinvested at the prevailing interest rate when the bond was initially purchased.
With a normal bond, investors are exposed to the risk of having to reinvest their coupons at a lower interest rate. For that reason, investors are not truly secure with any assurances that they are guaranteed to earn the yield, because they must account for the coupon reinvestment risk. One way to avoid this undesirable scenario is reinvest coupon payments, if they have a bunny bond that allows for this option.
If an investor chooses to reinvest all cash coupons back into the bond he is currently holding, it behaves similarly to a zero-coupon bond, as the investor receives no cash flow until maturity. A zero-coupon bond is a debt instrument that does not pay interest, known as a coupon, but is offered at a significant discount. For this reason, the investor reaps a profit when the bond reaches maturity and can be redeemed for its full face value.