What Is an Extendable Bond?
- An extendable bond is a long-term debt security that gives bondholders the option to extend its initial maturity to a later date.
- Extendable bonds can allow investors to take advantage of periods of declining interest rates without assuming the risk involved with long-term bonds.
- The price of an extendable bond is the price of a non-extendable bond plus the value of the extendable option.
Understanding Extendable Bonds
An extendable bond is a bond with an embedded option that gives bondholders, or issuers, the right to extend the maturity of the security. It may be seen as a combination of a straight shorter-term bond and a call option to purchase a longer-term bond. Since extendable bonds contain an option to extend the maturity date, a feature that adds value to the bond, they sell at a higher price, with a lower coupon rate, than non-extendable bonds.
When the option to extend the maturity is given to the bond investor, the bond is priced as a put bond. If the option to extend maturity lies in the hands of the issuer, the bond is priced as a callable bond. Depending on the specific terms of the extendable bond, the bondholder, the bond issuer, or both parties may have one or more opportunities to defer the repayment of the bond's principal, during which time interest or coupon payments continue to be made. Additionally, the bondholder or issuer may have the option to exchange the bond for one with a longer maturity, at an equal, or higher, rate of interest.
Investors purchase extendable bonds to take advantage of periods of declining interest rates without assuming the risk involved with long-term bonds. When interest rates are rising, extendable bonds act like bonds with shorter terms, and when interest rates fall, they act like bonds with longer terms.
Investors benefit more from this bond during periods of declining interest rates. When interest rates fall, the price of longer-term bonds rises to a greater degree than the price of shorter-term bonds. Thus, extendable bonds trade as though they were long-term bonds. The reverse is the result if interest rates increased.
The issuer hopes to pay a lower interest rate than would otherwise be the case, and the investor gains the potential upside of a longer-term bond with the price risk of a shorter-term bond. Since issuers continue paying interest on bonds that have been extended, the bonds will sell at a higher price (and lower yield) than other bonds because there is the possibility for a higher return. In short, the price of an extendable bond is the price of a straight or non-extendable bond plus the value of the extendable option.
An extendable bond is the opposite of a retractable bond. A retractable bond includes an option to redeem the bond earlier than its original maturity period. Both extendable and retractable bonds are intended to provide investors with the flexibility to respond to changing economic conditions and to take advantage of movements in interest rates.
Extendable Bond Example
A bondholder has purchased $10,000 worth of extendable bonds, with a fixed interest rate of 1.25% per year and a three-year term, from the bond issuer. After those three years pass, if the rate is still favorable, the investor decides to extend the bond's term for three more years to lock in that rate. The bond issuer might also very well choose to extend such a bond's term if its rates are favorable to the issuer.