cushion bond

Cushion Bond

A type of callable bond that sells at a premium because the issued coupon payments are above market interest rates.

Notes:

Mostly chosen by investors interested in generating high income conservatively. As interest rates rise, the cushion bond depreciates less than regular bonds, since it already pays a premium. On the other hand, as interest rates fall, the cushion bond's value appreciates less due to the risk of the company calling the bond.

See also: Callable Bond, Forced Conversion, Premium

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cushion bond

A high-coupon bond that sells at a price only slightly above par because of a call provision permitting the issuer to repurchase the security near its current price. A cushion bond has an unusually high current yield, little chance for a price rise, and considerable protection against falling prices caused by increased interest rates.

Can a cushion bond pad the conservative investor's backside against the impact of rising interest rates?

A cushion bond can protect a conservative investor against rising interest rates because the higher the coupon rate on a bond, the less dramatic the price change for a given shift in that bond's yield to maturity. This makes sense when one considers how much greater a percentage change 25 basis points is when yields are 5%, compared with yields at 10%. Furthermore, the longer the maturity period, the greater the price change for a particular move in that bond's yield to maturity. Because cushion bonds are by definition premium-priced bonds that trade on a yield to call basis, rather than a yield to maturity basis, their price swings account for shifts in interest rates for shorter time periods. Thus their price swings should be less dramatic when interest rates rise.

Stephanie G. Bigwood, CFP, ChFC, CSA, Assistant Vice President, Lombard Securities, Incorporated, Baltimore, MD