Finance

Puttable Bonds

Puttable Bonds

A puttable bond is a debt instrument that gives the bondholder the right to sell the bond to the issuer at a predetermined price at a specified time before maturity. Essentially, it’s a bond with an embedded put option, giving the bondholder the right, but not the obligation to demand early repayment from the issuer. Types of embedded options can be call option, put option, and extension option (extends the maturity of the bond).

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How do they work?

A bond is a debt instrument that makes periodic payments (called coupons) and the principal amount at the end of a specified time (called maturity). To reduce the cost of any debt, the issuer may provide the buyer with embedded options that are advantageous. A puttable bond is a bond that is advantageous to the investor since he can use his right to sell back the bond to the issuer in case it’s not advantageous for him to hold the bond any longer.

When would an investor with a Puttable bond exercise the option?

If he’s holding a bond that matures in 3 years, has a face value of $100, makes 5% coupon payments annually, and the interest rates rise from 5% to 6%, then the price of the Bond will fall (following the inverse relationship between bond prices and interest rates). It makes sense for the investor to get out of his current position with the bond he’s holding and reinvest into something with a higher interest rate. If he’s holding a bond with an embedded put option, this is doable. Hence, the put option provides security against rising interest rates and allows the investor to jump onto instruments with higher rates. This security of course means a lower cost of debt for the issuer because the put option is an advantage for the investor as he gets reduced reinvestment risk.

Convexity and Duration of Puttable Bonds:
The difference between the value of a puttable bond and an otherwise comparable option-free bond is the value of the embedded option.

Puttable Bonds

  • When the yield of the bond is relatively low compared to the bond in hand, the price of the puttable bond is basically the same as an option-free bond because no rational investor would sell the bond to the issuer at the put price. Therefore, the puttable bond will have a similar price/yield relationship to a comparable option-free bond.
  • As the price of the bond declines, the price of the bond first declines till the price reaches the put price, and then it stops declining because the put option provides an opportunity for the investor to exercise the option and redeem the bond.

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Pros and Cons to Bondholders & Issuing party:

For the Bondholder:
+ Lowered Reinvestment Risk as he can exercise the put option in case of increased interest rates.
+ Put option provides an opportunity to also liquidate the bond in case of unforeseen circumstances and received payment from the issuer.
+ Usually guaranteed (depending on the bond’s indenture) by a third party in case the issuer isn’t able to pay up in case of redemption
+ Puts a limit on the potential price depreciation because when interest rates rise, the price of the puttable bond will not go any lower than the strike price.
– Lower yield compared to bonds without the embedded put option

For the Issuer:
+ Lower cost of debt
+ Good way to raise capital in case the interest rate are expected to stay stagnant or decrease
– In case of an increase in interest rates, the issuer may be called upon to liquidate the bond

Example:

Consider a puttable bond with a $100 face value, 4.5% annual coupon rate, with 2 years maturity period, and a put option for selling the bond back to the issuer at the end of each year. The current spot rate is 3%, and the 1-year forward rate from now is 5%, and the 2-year forward rate from now is 4%. Would the seller sell back the bond or not?

The present value of the bond at the end of Year 1 would be:

Since the Put price > expected market price, the put option would be exercised at the end of year 1.
The Value of the puttable bond at t0 would be equal to the put price of $100 plus the 1-year coupon of $4.5 discounted using the 1-year spot rate.

Puttable Bonds2

If the bond had no put option embedded, then the value would have been $100.994, calculated using the PV at the end of Year 1 plus the coupon payment discounted using a 1-year spot rate.
The difference between the two is the value of the put,
$101.45 – $100.994 = $0.46

This is to say that the puttable bond in this scenario is $0.46 higher in value compared to a conventional bond.

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Conclusion:

Puttable bonds differ from a plain/vanilla bond in that they allow the bondholder to sell them back to the issuer at a pre-determined price before maturity date while conventional bonds pay the principal back only at their maturity date. The advantage provided is that it contains an inherent price floor i.e. a price below which the market price of the bond will not fall in an event of an increase in market interest rate. This disadvantage is that this floor is not provided for free and the yield on a puttable bond is lower than for a conventional bond. However, the value of a puttable bond converges to the value of a conventional bond as the bonds near their maturity date.

Author:  Aman Aggarwal

About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.

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