A putable bond (put bond or retractable bond) is a type of bond that provides the holder of a bond (investor) the right, but not the obligation, to force the issuer to redeem the bond before its maturity date. In other words, it is a bond with an embedded put option. Putable bonds are directly opposite to callable bonds.
If the embedded put option is exercised, the bondholder receives the principal value of the bond at par value. In certain cases, the bonds can be retracted as a result of extraordinary events. However, more frequently, the embedded put option can be exercised after a predetermined date.
How are put options important to investors and issuers?
Similar to callable bonds, the rationale behind putable bonds is related to the inverse relationship between interest rates and the price of bonds. Since the value of the bonds declines as interest rates rise, they provide investors with protection from potential interest rate increases.
At the same time, the bond issuers reduce their cost of debt by providing lower yields on the bonds. Investors accept lower yields in exchange for the opportunity to exit the investments in case of unfavorable market conditions.
How do putable bonds work?
Let’s consider the following example to understand how these bonds work:
ABC Corp. issues putable bonds with a face value of $100 and a coupon rate 4.75%. The current interest rate is 4%. The bonds will mature in 10 years.
The put option provides investors with the right to force ABC to redeem the bonds after the first five years.
If, after the first five years of the bonds’ life, interest rates have significantly increased, the investors do not have an incentive to keep the bonds until maturity. Rather than holding the bonds to maturity, they can exercise the embedded put option and receive the principal amount of their initial investment. They can then use the proceeds to invest in newly issued bonds with a higher coupon (interest) rate.
However, if interest rates remain the same or decline, the investors do not have an incentive to exercise the put option. They will likely hold the bonds until maturity. In such a scenario, both parties will enjoy the same payoff as in plain-vanilla bonds.
Note that the coupon rate of putable bonds may be slightly lower than that of plain-vanilla bonds. This is to compensate the issuer for the additional risk of investors exercising the put option.
How to find the value of a putable bond?
Valuing putable bonds differs from valuing plain-vanilla bonds because of the embedded put option. Since the option provides investors with the right to force the issuers to redeem the bonds, the put option affects the price of a (putable) bond.
The fair market price of a (putable) bond can be found using the following formula:
Price (Plain – Vanilla Bond) – the price of a plain-vanilla bond that shares similar features with a (putable) bond.
Price (Put Option) – the price of a put option to redeem the bond prior to maturity.
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