Bonds are the most traded financial security in the world. Entities that do not issue stock, including states and municipalities, issue bonds. Most bonds have a face value and coupon rate that remains set for the life of the bond despite changes in its market price. However, reset bonds differ. Reset bonds allow the adjustment of their initial interest rates on specific dates to enable the bonds to trade at their issuance value.
Reset Bonds Defined
A reset bond is a bond that increases its interest rate, or coupon rate, to bring the market value of the bond back to what it was on its original issue date or, more specifically, back to its original value. Issuing companies structure reset bonds this way to attract bondholders by protecting their principal investment. Reset bonds do not require the issuer to repurchase and reissue the bonds, only to reset the interest rate. Reset bonds typically reset on a specific date, but may also do so if a certain event occurs, such as a downgrade of the company's bonds by a credit-rating agency.
Suppose A-OK Corp. issues reset bonds with a face value or price of $1,000 and a coupon rate of 6 percent. If A-OK Corp.'s bond price drops below $900 before a specified date, the coupon rate will increase to 8 percent or another interest rate that returns the bond's market price to $1,000. If a rating agency downgrades A-OK's credit rating and the bond price drops to $920, A-OK does not reset the bond price. However, if the bond price drops to $895 before the second reset date, A-OK Corp. could reset its coupon rate to 7.5 percent to bring the bond’s market price back to the original value.
Municipal Reset Bonds
Municipal reset bonds operate a little differently. These bonds typically have interest rates that periodically reset at multiples of seven days. Other municipal reset bonds reset daily. Despite the frequent resets, municipal reset bonds often have longer maturities of five to 30 years. Generally, municipal resets are sold via auction, which determines the rate. The auction rate remains until the next reset date.
Although resetting coupons on specific dates or in the event specific events occur protects bondholders, resetting can cause financial difficulties for the issuer. When a coupon is reset -- most commonly, increased -- it increases the amount of cash the issuer must pay out to bondholders. In extreme situations, resetting bonds can lead to the issuer's failure, or bankruptcy, when the issuer does not have sufficient cash flow to meet the higher payouts.
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