What Is a Cushion Bond?
A cushion bond is an investment that is sold at a premium to similar bonds because it comes with a relatively high coupon rate. The promise of a higher return serves as a "cushion" for the investor against an unexpected increase in market rates.
The cushion bond is a type of callable bond, so the issuer may opt to pay it off early.
- A cushion bond is a type of callable bond that sells at a premium over other bonds because it offers a coupon rate that is above prevailing market interest rates.
- Investors will benefit most from cushion bonds when interest rates fall, stay flat, or rise slowly over a long period of time.
- A cushion bond's call feature has pricing on a yield-to-call (YTC) basis rather than a yield-to-maturity (YTM) basis.
Understanding the Cushion Bond
Cushion bonds get their name from their resilience to the fluctuations of interest rates. They have a higher interest rate, or coupon rate, than prevails in the market at the time of their issue, so the investor will have a degree of protection against inflation during the life of the bond.
Investors benefit most from owning cushion bonds when interest rates fall or stay flat between the time of the bonds' purchase and their maturity.
A cushion bond's call feature is priced on a yield-to-call (YTC) basis rather than a yield-to-maturity (YTM) basis. This means that the issuer may choose to repay the bond before its maturity date.
Who Buys Cushion Bonds?
Investors in cushion bonds are generally conservative investors who seek to avoid volatility even in a fixed-income portfolio. They are willing to sacrifice upside potential in a bond portfolio in favor of lower downside risk.
An advantage of cushion bonds is that the added interest payments give the investor an investment hedge. The larger coupon payment means that the investor will get their original investments back quicker.
This faster breakeven date creates an additional hedge by lowering the length of time that the investor’s money is at risk. The larger coupon payment provides more cash flow, which can be reinvested in other higher-yielding instruments.
When Cushion Bonds Work Best
The lower sensitivity of a cushion bond is desirable when interest rates are rising. Its above-market coupon rate and call feature will diminish the impact of higher interest rates in the marketplace.
Because of these attributes, a cushion bond's market price will decline less over time than other comparable bonds. However, the investor is still susceptible to a loss if interest rates rise too rapidly, eroding the built-in advantage of the coupon. In that case, the investor has locked in an unfavorable return for the money.
Cushion bonds are a choice for conservative investors who want to prevent volatility in a fixed-income portfolio.
When interest rates are falling, however, the cushion bond will appreciate in price to a lesser extent than other comparable non-callable bonds. In addition, the issuer might exercise the right to call the bond which would leave the bondholder vulnerable to reinvestment risk.
Cushion Bond Example
Say an investor purchases a cushion bond with a coupon rate of 6% at a time when market interest rates are at 2%.
Rates then increase to 3%. That change is a relative increase of 33% (one percent divided by three percent).
But for the investor who purchased the cushion bond with a coupon rate of 6% when the market rate was at 2%, the increase of 1% is a relative increase of 16% of the bond's coupon (1% divided by 6%).