Cushion Bonds

Taking On Call Risk & Giving Up Interest Rate Risk - This strategy involves purchasing high coupon bonds ("cushion bonds") trading to a short call (not very far in the future). By purchasing a bond that has a short call (or potential short call), you are taking on call risk. Because the high coupons are trading to a short call, you are actually giving up interest rate risk. Let us explain with an example. If a high coupon bond was not callable, it would be, for example, trading at 110; but, because the bond is callable shortly at 100, the bond trades at only 101. The "cushion" in this example is nine points, the difference between where the bond would trade if it were non-callable (110) and where it is actually trading (101). What this means is that the bond market in general would have to drop over nine points (the cushion) before the value of this particular bond's price would drop much, if at all. An added benefit with large coupon cushion bonds is that if they pass their call, you keep getting that big coupon longer than the market had anticipated.