Putable Bond

What is Definition of Putable Bond?

A putable bond comes with an embedded put option that provides the holder (i.e. the investor) to force the issuer (i.e. the borrower) to redeem the bond prior to its maturity date.

The put option can be exercised either after a specified period, or on specified dates before the date of maturity.

If the put option is exercised, the bondholder must sell the bond back to the issuer at a specified price, most often at the par value (or “face value”) of bond.

From the perspective of the bondholder, the primary benefit of the put option is protection against the risk of rising interest rates in the financial markets.

In effect, the bondholder has the option to redeem the bond prematurely and reinvest the funds at the higher prevailing interest rates.

Ultimately, the decision to exercise the put option comes down to whether the expected return outweighs the risk undertaken, i.e. the risk-reward trade off is deemed worthwhile.

The embedded put option functions as incentive for investors to purchase a bond with a lower yield relative to comparable bonds without the put feature.

• Rising Interest Rates → If interest rates were to rise, the bondholder can redeem the bond back to the issuer. Once the funds are returned, the bondholder can then reinvest the capital in more favorable conditions to earn a higher return.
• Falling Interest Rates → In contrast, if rates were to fall, a rational bondholder would opt to hold the bond until maturity since exercising the put option would be counterintuitive.

However, the trade-off here is the flexibility offered to the bondholder is in exchange for a lower yield than comparable plain, vanilla bonds without the put option.

What are the Features of Putable Bonds?

Putable bonds are characterized by several unique features that distinguish them from other forms of debt securities.

1. Put Option → The embedded put option is the defining attribute of a puttable bond, which as mentioned earlier, provides the bondholder with the right, yet not the obligation, to sell the bond back to the issuer before its maturity at a predetermined price.
2. Coupon Rate → Like other debt securities, puttable bonds pay periodic interest payments—otherwise referred to as “coupon payments” to the bondholder—based on a fixed interest rate agreed upon on the date of original issuance.
3. Maturity Date → The lending agreement of the bond states its maturity date, which is the date by which the bond’s principal must be repaid in full if the bondholder decides not to exercise the put option.
4. Put Dates → Putable bonds have predefined dates on which the bondholder can exercise the put option. The dates must be explicitly stated in the contractual agreement to formalize the bond issuance.
5. Put Price → In most cases, the price of a putable bond at issuance is the par value. However, the pricing of the bond can fluctuate in the secondary market based on the current interest rate environment and other external factors.
6. Lower Yield → The flexibility provided from the put option (and protection against rising rates) comes at the cost of offering a lower yield compared to bonds with similar risk-return profiles without the embedded put option.

How Does a Putable Bond Work?

The step-by-step process of a putable bond issuance is as follows.

1. Issuance → The issuer sells a bond with the embedded put option to an investor. For the most part, the bond issuance is standard with a stated maturity date, a coupon rate and the par value. However, the feature that sets putable bonds apart is the put option that allows the investor to sell the bond back to the issuer either past a specified date or only on certain dates.
2. Coupon Payments → Over the term of the bond, the issuer is obligated to service periodic interest payments to the bondholder.
3. Put Option Exercise → If interest rates rise, the bond becomes less appealing from a yield perspective since higher returns can be earned on more recent bond issuances. The inclusion of the put option means the investor can avoid missing the potential upside by exercising the option, wherein the bondholder must sell the bond back to the issuer at the predetermined price.
4. Redemption → If the investor exercises the put option, the issuer is now obligated to purchase the bond.
5. Reinvestment → Upon exercising the put option, the investor can redeploy the returned funds into other opportunities offering a potentially higher return from the now higher interest rates.

What is the Difference Between a Putable Bond vs. Callable Bond?

The mechanics of putable bonds and callable bonds are conceptually similar. Yet, the distinction between the two bond types boils down to the recipient of the rights, i.e. the option.

1. Putable Bond → A puttable bond provides the bondholder with the right, but not the obligation, to force an early repayment of the principal from the issuer. The incentive to exercise the embedded put option would be if interest rates were to rise, as the returned capital can be reinvested at a higher rate. Said differently, a puttable bond enables the lender to manage the risk of falling bond prices caused by rising interest rates.
2. Callable Bond → A callable bond, or “redeemable bond”, offers the issuer the right, but not the obligation, to repay the bond before its stated maturity date. Unlike a puttable bond, the option is far more likely to be exercised if interest rates fall after the original bond issuance date. Therefore, the issuer can pay off its existing debt obligations in order to reissue bonds at a lower interest rate, i.e. the call feature allows the issuer to manage the risk of paying unnecessarily high interest rates under market conditions where rates have declined.

Briefly put, the difference between puttable and callable bonds is which party—the lender or borrower—receives the right to initiate an early repayment (and thus benefits).

• Puttable Bonds → Bondholders
• Callable Bonds → Issuer

What is an Example of a Puttable Bond?

Suppose an investor purchased a puttable bond issued by a corporation with the following terms:

• Par Value = $1,000
• Coupon Rate = 5.0% per annum
• Maturity = 10 Years
• Put Dates = Post-Year 4

If not exercised, the investor can expect to receive $50 (5.0% × $1,000) in interest per year for the next ten years.

If by the end of year 4, the market interest rate has climbed upward to 7.0%, an increase of 2.0% from the original issuance date, the investor can now purchase new bonds that pay $70 per year instead of $50.

Given the potential to reap more monetary benefits, the investor could decide to exercise the put option to sell the bond to the corporation for its face value of $1,000.

Once sold, the bondholder can reinvest the returned funds to invest in a recent bond issuance that pays 7.0% per year.

Because of the put option, the investor could capitalize on the rising interest rate environment, without the need to wait until the bond’s maturity date.

How to Calculate the Value of Put Bonds

The process of estimating the fair value of a putable bond is rather complicated, namely because of the embedded put option.

The fair value of a puttable bond is the present value (PV) of its future cash flows, inclusive of the bond’s periodic interest payments and its face value at maturity (or at specified put dates), plus the value of the embedded put option.

1. Present Value of Bond Cash Flows → The present value (PV) of the bond’s future cash flows can be determined by discounting each anticipated coupon payment and the face value of the bond back to the present using an appropriate discount rate, i.e. the yield to maturity (YTM).
2. Present Value of Put Option → The complex part of the calculation, where opinions can quickly diverge, is calculating the value of the put option, which can be determined using an option pricing model such as the Black-Scholes model. Those sorts of models often consider various factors like the bond price, the strike price, the time until the put date, the risk-free rate (rf), and volatility.
3. Sum of PV of Bond CFs and Put Option → The sum of these two components represents the fair value of the puttable bond, i.e. traditional bond pricing followed by estimating the fair value of the put option provision.

Note: The calculation steps discussed here are a highly simplified overview of determining the fair value of a puttable bond.

^{Price-Yield Curve of Puttable Bonds (Source: AnalystPrep)}

What are the Pros and Cons of Putable Bonds?

Puttable bonds offer the bondholder several advantages but also possess numerous drawbacks.