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Puttable bonds are unique investment vehicles which provide purchasers with flexibility and security. They are among several alternatives in fixed-income securities globally.
These bonds give their holders the right to sell them back to the original issuer at a predetermined price before they become due. It may have an attractive feature when rates rise, or credit deteriorates. For those who purchased such securities, it serves as a backstop mechanism.
This article will explore the meaning of puttable bonds, how they work, and the advantages and disadvantages of puttable bonds.
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What are puttable bonds?
A puttable bond is a form of debt that permits the principal to be repaid early. You can choose to use this put option either after a certain period or on specific dates before it reaches maturity.
This is great for those who own bonds because it covers them if the interest rates go up in the economy. For example, one can cash out before their bonds mature and reinvest at higher current yields. However, an expectation of increased returns must always exist. Otherwise, they will not be implemented because the risk taken should always justify the expected reward.
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How do puttable bonds work?
Let’s use a simple example to understand how a puttable bond works:
The State Bank of India issues puttable bonds with a face value of ₹1000. These bonds will mature in 15 years. The following explanation demonstrates how it operates:
- Face value: ₹1,000
- Coupon rate: 5.25%
- Current interest rate: 5%
Those who invest in these bonds may choose to exercise the put following the initial seven years. In case interest rates go up within that time frame, the company can buy back the bond from the bondholder if they so wish.
After seven years, interest rates have increased to 6.5%. Bondholders decide to exercise the put option. The bond is repurchased by the corporation at a price of ₹1,050, for instance. This permits the investors to recover their money and invest in better-earning prospects.
If interest rates remain around 5% or decline, bondholders may not exercise the put. They continue to receive coupon payments until maturity. Holding the bond becomes more attractive, especially if other investment options offer lower yields.
Advantages of puttable bonds
- Flexible investment: If necessary, bondholders can sell their puttable bonds back to the issuer. As they decide to do so, the investors get a chance to withdraw their investment before it reaches the maturity stage.
- Higher liquidity: Bonds of a traditional nature are less liquid than bonds that can be put. This is because the ability to exercise a put option improves liquidity by enabling investors to leave an investment.
- Risk reduction: Suitable for moderate to conservative investors. The embedded put option protects interest rates and credit risks. Bondholders can sell back the bonds if they anticipate issues.
- Inherent price floor: Puttable bonds have a minimum market price (price floor). Unlike stocks, the invested capital won’t be reduced to zero. Safer investment option.
- Portfolio diversification: Adding puttable bonds diversifies a portfolio. Balances risk from other aggressive investments. Ideal for income-seeking investors.
Must read: Take a tour of the economic concept of the ‘liquidity trap’.
Disadvantages of puttable bonds
- Lower investment returns: Puttable bonds typically offer lower coupons and yields compared to traditional and callable bonds. It is not ideal for investors seeking high returns or substantial capital appreciation.
- Higher investment cost: Puttable bonds are more expensive than straight bonds or callable bonds. The added cost compensates for the embedded put option’s value.
- Liquidity and default risks: Liquidity and credit risks are still present for investors. It is uncertain whether bondholders can sell back bonds or not. Issuing bodies need enough money to repay puttable bonds.
- Unguaranteed put option: The put option isn’t guaranteed. Struggling issuers may be unable to redeem bonds. Bondholders could be unable to liquidate their investments.
- Complex valuation: Valuing puttable bonds is intricate due to the put option. Option pricing models (like binomial or Black-Scholes) are needed.
Callable bond vs puttable bond
| Callable bonds | Puttable bonds |
| A callable bond is a bond that the issuer can pay off before it matures. The call date represents when it can be redeemed at the earliest. | A puttable bond enables a lender to sell it back to the borrower before it becomes due. The earliest date for this option is called the put date. |
| Issuers benefit from callable bonds as they can refinance debt at lower interest rates when the market is good. | Flexibility is offered by puttable bonds to bondholders. If the rates of interest rise high or if there is a change in market conditions, then the bondholders are free to use their put option and take back their principal. |
| Before maturing, callable bonds can be called by the issuer who issued them which, exposes investors to such a risk. This could leave them vulnerable to reinvestment risk. | To make up for investors’ decision to put an option, issuers agree to take slightly lower yields on puttable bonds. |
Bottomline
Puttable bonds can be a desirable investment, especially for people who are trying to achieve both income stability and flexibility in their portfolio. People who understand the details and potential benefits of puttable bonds can make wise decisions that match their financial objectives as well as risk capacity.
FAQs
Higher coupon rates are offered by callable bonds, which make them attractive to investors seeking income. However, they can also be redeemed earlier than expected by the issuer, thus spoiling long-term plans to earn money from them. Besides this, when you invest in callable bonds, it means betting against a substantial fall in interest rates because the bond may be redeemed by the person who issued it, and this would mean that higher returns could not be realised.
Higher coupon rates are offered by callable bonds, which make them attractive to investors seeking income. But they can also be redeemed earlier than expected by the issuer, thus spoiling long-term plans of earning money from them. Besides this, when you invest in callable bonds, it means betting against a substantial fall in interest rates because the bond may be redeemed by the person who issued it and this would mean that higher returns could not be realised.
Pb, or the price of a putable bond, can be calculated by adding Pc, which represents the present value of cash flows from the bond, with VAp representing the value attached to a put option. This put option gives bondholders the right to demand their money back before the final redemption date. The exact value of a put option relies on prevailing market conditions as well as an agreed-upon date for its exercise.
Sinkable bonds from a reserve fund are safer investments. The issuer regularly repurchases bonds from the open market using reserve funds. These bonds allow debtors to repay and refinance at lower rates if interest rates fall below the nominal rate, lowering borrowing costs. Concerns exist about whether this gradual redemption of bonds using the reserve provides investors with safety since the bonds are backed by cash.
Because of the extra security measure in the form of an embedded put option, puttable bonds are usually priced slightly higher than conventional bonds. The bondholders can use this option to sell the bonds back to the issuer before their maturity dates. Although it may decrease risks for investors, such safeguarding also causes lesser yields than regular bonds. So, putable bonds are considered more expensive, but they offer a trade-off between safety and potential returns.