What is a Puttable Bond?
A puttable 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, a puttable bond is a bond with an embedded put option. Puttable bonds are directly opposite to callable bonds.
If the embedded put option of the puttable bond is exercised, the bondholder receives the principal value of the investment set 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 the predetermined date.
How are puttable bonds important to investors and issuers?
Similar to callable bonds, the rationale behind puttable bonds is related to the inverse relationship between interest rates and the price of bonds. Since the value of the bonds declines as the interest rate rises, 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 puttable bonds work?
Let’s consider the following example to understand how the bonds work:
ABC Corp. issues puttable bonds with a face value of $100 and a coupon rate 4.75%, while the current interest rate is 4%. The bonds will mature in 10 years.
The embedded put option of the bonds provides investors with the right to force ABC Corp. to redeem the bonds after the first five years.
If after the first five years of the bonds’ life, the interest rate increases, the investors will not have an incentive to keep the bonds until the maturity. Rather than holding the bonds to maturity, they can exercise the embedded put option and receive the principal amount of their initial investment. Then, the investors can use the proceeds to invest in newly issued bonds with a higher interest rate.
However, if the interest rate remains the same or declines, the investors will not have an incentive to exercise the put option and will 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 puttable bonds is slightly higher than the interest rate. The cost of debt for the bonds’ issuers is a trade-off for the embedded put option that provides protection to investors.
How to find the value of a puttable bond?
Valuing puttable bonds differs from valuing plain-vanilla bonds because of the embedded put option. Since the option provides investors with the right, but not the obligation, to force the issuers to redeem the bonds, the put option positively affects the price of a (puttable) bond.
The price of the (puttable) 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 (puttable) bond.
- Price (Put Option) – the price of a put option to redeem the bond prior to maturity.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: