A bunny bond is a coupon bond that gives the speculator the privilege to get coupon installments in cash or in additional bonds with the same coupon as the underlying bond. The purpose is to offer the investor protection from reinvestment risk (G. L. Gastineau, M. P. Kritzman, 1999, p. 47). This type of bond is also known as:
- a multiplier bond,
- a guaranteed coupon reinvestment bond.
In other words, a bunny bond is a bond or note structure that gives the holder a progression of alternatives to get each interest coupon in cash or to reinvest it in the same bond at par on the interest payment date. A holder choosing to reinvest all coupons thusly would make what could be compared to a zero-coupon bond. The intrigue of the guaranteed coupon reinvestment security is that it gives a holder adaptability to maintain a strategic distance from the reinvestment hazard related with having to reinvest coupons at lower rates than the first yield on the bond (G. L. Gastineau, M. P. Kritzman, 1999, p. 157).
"A zero-coupon bond is a bond, that pays a specified amount (called its face value or par value) at a specified time (called maturity). At times prior to maturity, the value of this asset is less than its face value, provided the interest rate is always greater than zero" (S. Shreve, 2005, p. 143). "A zero-coupon bond with principal £1 maturing in a year is precisely the same as receiving the sum of £1 in a year" (M. S. Joshi, 2003, p. 23).
Comparing Price Risk And Reinvestment Risk
The price risk identifies the current market value of the bond portfolio, while reinvestment risk relates to the income the portfolio produces. If you hold long-term bonds, you will face significant price risk because the value of your portfolio will decline if interest rates rise, but you will not confront much reinvestment risk because your income will be steady. On the other hand, if you hold short-term bonds, you will not be exposed to much price risk, but you will be exposed to significant reinvestment risk. A long-term zero coupon will have a significant level of price risk and relatively little reinvestment risk. In contrast, a short-term bond with a high coupon rate will have low price risk, but considerable reinvestment risk (E. F. Brigham, J. F. Houston, 2012, p. 237).
Examples of Bunny Bond
- Zero-Coupon Bunny Bond: This type of bond pays no coupon interest but instead gives the investor the right to receive additional zero-coupon bonds with the same face value as the original bond.
- Convertible Bunny Bond: This type of bond pays a coupon interest rate, but also gives the investor the right to convert the bond into equity shares of the company at a predetermined conversion rate.
- Exchangeable Bunny Bond: This type of bond pays a coupon interest rate, but also gives the investor the right to exchange the bond for equity shares of another company at a predetermined exchange rate.
- Variable Rate Bunny Bond: This type of bond pays a coupon interest rate that can be adjusted over time in order to maintain a certain yield. The investor has the right to receive additional bonds with the same coupon rate if the rate is adjusted downwards.
Advantages of Bunny Bond
The advantages of bunny bonds include:
- Reduced reinvestment risk: As the investor can receive coupon payments in cash or in additional bonds with the same coupon as the underlying bond, reinvestment risk is reduced.
- Flexibility: Bunny bonds offer the flexibility of receiving payments in cash or in additional bonds, allowing the investor to choose the option most beneficial to their own financial goals.
- Lower cost: Since the coupon payments can be received in additional bonds, the cost of the investment is lower than if the investor received cash payments.
- Enhanced liquidity: The investor can easily convert the bonds into cash if necessary.
Limitations of Bunny Bond
Bunny bonds come with a number of limitations that investors should be aware of. These include:
- The coupon payments of bunny bonds are usually set at lower levels than those of standard bonds, making them less attractive for some investors.
- Bunny bonds are typically not actively traded on the secondary market, meaning that investors may have difficulty selling them if they need to free up capital.
- The reinvestment risk of bunny bonds cannot be completely eliminated, as the bonds may still be subject to changes in interest rates.
- Bunny bonds may also be subject to higher transaction costs, as issuers may charge fees for the right to receive additional bonds.
- The coupon payments of bunny bonds may vary significantly, depending on the issuer's ability to make payments and the overall health of the bond market.
The following list expands on the concept of Bunny Bonds to provide investors with additional protection against reinvestment risk.
- Zero-Coupon Bond - A zero-coupon bond is a bond that does not pay any regular interest payments. Instead, it is sold at a deep discount from its face value and pays out the full face value on maturity. This type of bond is often used to hedge against reinvestment risk, as the investor does not have to worry about reinvesting their coupon payments.
- Floating Rate Bond - A floating rate bond pays a variable interest rate that is adjusted periodically according to a benchmark rate. This type of bond helps to hedge against reinvestment risk, as the interest rate adjusts with the changes in the market.
- Convertible Bond - Convertible bonds are bonds that can be converted into a specified number of shares of the issuer’s stock at a predetermined price. These bonds are often used to hedge against reinvestment risk, as the investor can convert their bond into stock if the interest rate falls.
- Indexed Bond - Indexed bonds are bonds that pay a coupon based on an index, such as the S&P 500 or the 10-Year Treasury yield. This type of bond helps to protect against reinvestment risk, as the interest rate is tied to the performance of the underlying index.
In summary, Bunny Bonds offer investors protection against reinvestment risk, and there are a number of other approaches that can be used to achieve the same goal, such as Zero-Coupon Bonds, Floating Rate Bonds, Convertible Bonds, and Indexed Bonds.
|Bunny Bond — recommended articles
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- Brigham E. F., Houston J. F. (2012), Fundamentals Of Financial Management, Cengage Learning, UK, p. 237
- Buljevich E. C., Park Y. S. (1999), Project Financing And The International Financial Markets, Springer Science & Business Media, Germany
- Clark J. (2014), International Dictionary Of Insurance And Finance, Routledge, UK
- Eastaugh S. R. (1994), Facing Tough Choices: Balancing Fiscal And Social Deficits, Praeger, USA
- Flood J. M. (2014), Wiley GAAP 2015: Interpretation And Application Of Generally Accepted Accounting Principles, John Wiley & Sons, USA
- Gastineau G. L., Kritzman M. P. (1999), Dictionary Of Financial Risk Management, John Wiley & Sons, USA, p. 47 and 157
- Gibson N. (2003), Essential Finance, Wiley, USA
- Joshi M. S. (2003), The Concepts And Practice Of Mathematical Finance, Cambridge University Press, UK, p. 23
- Lacalle D. (2014), Life In The Financial Markets: How They Really Work And Why They Matter To You, John Wiley & Sons, USA
- Parekh N. (1995), Derivatives: A Practitioner's Guide, Euromoney Publications PLC, UK
- Shreve S. (2005), Stochastic Calculus For Finance I: The Binomial Asset Pricing Model, Springer Science & Business Media, Germany, p. 143
Author: Elżbieta Woyke