What Is a Cushion Bond?
A cushion bond is an investment that is purchased at a best magnificence to similar bonds because it comes with a somewhat best coupon rate. The promise of a higher return serves as a “cushion” for the investor against an unexpected increase in market fees.
The cushion bond is a type of callable bond, so the issuer would most likely come to a decision to pay it off early.
Key Takeaways
- A cushion bond is a type of callable bond that sells at a best magnificence over other bonds because it supplies a cut price rate that is above prevailing market interest rates.
- Patrons will benefit most from cushion bonds when interest rates fall, stay flat, or rise slowly over a prolonged time frame.
- A cushion bond’s title feature has pricing on a yield-to-call (YTC) basis slightly than a yield-to-maturity (YTM) basis.
Working out the Cushion Bond
Cushion bonds get their identify from their resilience to the fluctuations of interest rates. They’ve the following interest rate, or coupon rate, than prevails to be had out there at the time of their issue, so the investor can have some degree of protection against inflation during the life of the bond.
Patrons benefit most from proudly proudly owning cushion bonds when interest rates fall or stay flat between the time of the bonds’ achieve and their maturity.
A cushion bond’s title feature is priced on a yield-to-call (YTC) basis slightly than a yield-to-maturity (YTM) basis. Which means that the issuer would most likely choose to repay the bond forward of its maturity date.
Who Buys Cushion Bonds?
Patrons in cushion bonds are maximum frequently conservative patrons who seek to steer clear of volatility even in a fixed-income portfolio. They are ready to sacrifice upside potential in a bond portfolio in need of lower problem risk.
An advantage of cushion bonds is that the added passion expenses give the investor an investment hedge. The larger coupon price signifies that the investor will get their distinctive investments once more sooner.
This faster breakeven date creates an additional hedge by the use of lowering the length of time that the investor’s money is at risk. The larger coupon price provides more money glide, which can be reinvested in numerous higher-yielding gear.
When Cushion Bonds Artwork Highest conceivable
The lower sensitivity of a cushion bond is interesting when interest rates are rising. Its above-market coupon rate and call feature will diminish the impact of higher interest rates to be had available on the market.
On account of the ones attributes, a cushion bond’s market price will decline a lot much less over time than other identical bonds. Then again, the investor remains to be liable to a loss if interest rates rise too all of a sudden, eroding the built-in advantage of the coupon. If that is so, the investor has locked in an unfavourable return for the money.
Cushion bonds are a decision for conservative patrons who want to prevent volatility in a fixed-income portfolio.
When interest rates are falling, however, the cushion bond will acknowledge in price to a lesser extent than other identical non-callable bonds. In addition to, the issuer would most likely exercise the right to call the bond which would go away the bondholder at risk of reinvestment risk.
Cushion Bond Example
Say an investor purchases a cushion bond with a cut price rate of 6% at a time when market interest rates are at 2%.
Fees then construct as much as 3%. That vary is a relative increase of 33% (one % divided by the use of 3 %).
Then again for the investor who purchased the cushion bond with a cut price rate of 6% when {the marketplace} rate was once as soon as at 2%, the upward thrust of 1% is a relative increase of 16% of the bond’s coupon (1% divided by the use of 6%).
