Cushion Bond

What Is a Cushion Bond?

A cushion bond is an investment that is sold at a premium to comparative bonds since it accompanies a relatively high coupon rate. The commitment of a higher return fills in as a "cushion" for the investor against an unforeseen increase in market rates.

The cushion bond is a type of callable bond, so the issuer might opt to pay it off right on time.

Understanding the Cushion Bond

Cushion bonds get their name from their versatility to the vacillations of interest rates. They have a higher interest rate, or coupon rate, than wins in the market at the hour of their issue, so the investor will have a degree of protection against inflation during the life of the bond.

Investors benefit most from claiming cushion bonds when interest rates fall or remain flat between the hour of the bonds' purchase and their maturity.

A cushion bond's call feature is priced on a yield-to-call (YTC) basis as opposed to a yield-to-maturity (YTM) basis. This means that the issuer might decide to repay the bond before its maturity date.

Who Buys Cushion Bonds?

Investors in cushion bonds are generally conservative investors who try to stay away from volatility even in a fixed-income portfolio. They will sacrifice upside potential in a bond portfolio for lower downside risk.

An advantage of cushion bonds is that the additional interest payments give the investor an investment hedge. The bigger coupon payment means that the investor will get their original investments back speedier.

This quicker breakeven date makes an extra hedge by bringing down the timeframe that the investor's money is at risk. The bigger coupon payment gives more cash flow, which can be reinvested in other higher-yielding instruments.

At the point when Cushion Bonds Work Best

The lower sensitivity of a cushion bond is attractive when interest rates are rising. Its above-market coupon rate and call feature will lessen the impact of higher interest rates in the marketplace.

Due to these properties, a cushion bond's market price will decline less over the long haul than other comparable bonds. Nonetheless, the investor is as yet powerless to a loss on the off chance that interest rates rise too quickly, eroding the implicit advantage of the coupon. In that case, the investor has locked in an unfavorable return for the money.

Cushion bonds are a decision for conservative investors who need to prevent volatility in a fixed-income portfolio.

At the point when interest rates are falling, notwithstanding, the cushion bond will see the value in price less significantly than other comparable non-callable bonds. Furthermore, the issuer could exercise the right to call the bond which would leave the bondholder powerless against reinvestment risk.

Cushion Bond Example

Say an investor purchases a cushion bond with a coupon rate of 6% when market interest rates are at 2%.

Rates then increase to 3%. That change is a relative increase of 33% (one percent partitioned by three percent).

In any case, 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% partitioned by 6%).

Highlights

• Investors will benefit most from cushion bonds when interest rates fall, remain flat, or rise gradually over a long period of time.
• A cushion bond's call feature has pricing on a respect call (YTC) basis as opposed to a respect maturity (YTM) basis.
• A cushion bond is a type of callable bond that sells at a premium over different bonds since it offers a coupon rate that is above winning market interest rates.