Puttable bond
Encyclopedia
Puttable bond is a bond
with an embedded
put option. The holder of the puttable bond has the right, but not the obligation, to demand early repayment of the principal. The put option
is exercisable on one or more specified dates.
This type of bond protects investors: if interest rates rise after bond purchase, the future value of coupon payments will become less valuable. Therefore, investors sell bonds back to the issuer and may lend proceeds elsewhere at a higher rate. Bondholders are ready to pay for such protection by accepting a lower yield
relative to that of a straight bond.
Of course, if an issuer has a severe liquidity crisis
, it may be incapable of paying for the bonds when the investors wish. The investors also cannot sell back the bond at any time, but at specified dates. However, they would still be ahead of holders of non-puttable bonds, who may have no more right than 'timely payment of interest and principal' (which could perhaps be many years to get all their money back).
The price behaviour of puttable bonds is the opposite of that of a callable bond
. Since call option
and put option
are not mutually exclusive
, a bond may have both options embedded.
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
with an embedded
Embedded option
An Embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options...
put option. The holder of the puttable bond has the right, but not the obligation, to demand early repayment of the principal. The put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
is exercisable on one or more specified dates.
This type of bond protects investors: if interest rates rise after bond purchase, the future value of coupon payments will become less valuable. Therefore, investors sell bonds back to the issuer and may lend proceeds elsewhere at a higher rate. Bondholders are ready to pay for such protection by accepting a lower yield
Yield to maturity
The Yield to maturity or redemption yield of a bond or other fixed-interest security, such as gilts, is the internal rate of return earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments...
relative to that of a straight bond.
Of course, if an issuer has a severe liquidity crisis
Liquidity crisis
In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...
, it may be incapable of paying for the bonds when the investors wish. The investors also cannot sell back the bond at any time, but at specified dates. However, they would still be ahead of holders of non-puttable bonds, who may have no more right than 'timely payment of interest and principal' (which could perhaps be many years to get all their money back).
The price behaviour of puttable bonds is the opposite of that of a callable bond
Callable bond
A callable bond is a type of bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches the date of maturity. In other words, on the call date, the issuer has the right, but not the obligation, to buy back the bonds from the bond...
. Since call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
and put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
are not mutually exclusive
Mutually exclusive
In layman's terms, two events are mutually exclusive if they cannot occur at the same time. An example is tossing a coin once, which can result in either heads or tails, but not both....
, a bond may have both options embedded.
Pricing
Price of puttable bond = Price of straight bond + Price of put option- Price of a puttable bond is always higher than the price of a straight bond because the put option adds value to an investor;
- Yield on a puttable bond is lower than the yield on a straight bond.
External links
- A model to price puttable corporate bonds with default risk, David Wang, Journal of Academy of Business and Economics, International Academy of Business and Economics, 2004
- Introduction to Pricing Approach, Resolution Financial Software