Straight bonds are usually held till the maturity date for repayments of the principal amount. Depending on several factors, the investor may opt to withdraw the money with bonds.
A Puttable or simply Put bond has the additional characteristic of having a put option with the bond. The Put option gives the investor a right to demand the investment before the maturity date.
How Puttable Bonds Work?
Investors look to receive coupons or interest on their investments in bonds. The issuers look for cash to fund their business needs. Bonds usually pay regular coupon payments at a determined interest rate.
The low yield on bonds may not attract investors, especially in a volatile economic market. The issuers attach an additional provision with the bond of a put option to attract the investors.
A Put option attached with a bond offers flexibility to the investor to demand the principal investment back from the borrower before the maturity date. As many investors look to trade the bonds in secondary markets, it also makes the bonds attractive reselling security.
The repurchase price of the bond is usually set at Par or face value. However, it can be agreed upon by both parties before the bond purchase agreement is completed. Other terms affecting the bond may also include the covenant of the Put option exercise date.
The borrower may add the clause for barring the investor to exercise the Put option before a certain period. It usually happens if the bond has a long maturity date.
Why Investors Exercise the Put Option?
In the first place, the bonds are usually low-risk and low-reward investments. Investors look to trade the bonds in secondary markets to make profits. Bonds with additional provisions such as the Put option offers greater flexibility and lure in the investors.
Any changes in interest rates make the bond’s supply and demand change inversely. If the interest rates increase, it makes the existing bonds less attractive to investors. As the newer bonds issued will offer higher coupon payments than the existing ones. This Inverse interest rate relation plays an important role in secondary markets for bond trade.
In private markets, the investors may be able to secure Puttable bonds with lower yields and a discount issue price. Even without a discount issue price, the Puttable bonds attract more investors in secondary markets due to lower risk of price and default.
The Put option practically makes the bonds sell at a premium price than Face value. Private investors look to capitalize on quick gains with the premium price than low coupon yields.
Another situation may arise due to a default risk of the issuer. The investor may feel that the borrower will not be able to repay the amount by t maturity due to a weak financial position. In that scenario, the Put option doesn’t attract other investors with a risky bond investment.
When investors look to exercise the Put option due to a change in the interest rate, the borrowers may offer a bond Swap to the investors. In that situation, if the investor demands for the principal, the issuers offer them a similar value bond with new interest rates. The bond Swap fulfills the needs of both parties in the bond contract.
Advantages of the Puttable Bonds:
Puttable bonds offer lower yields to the investors. But it also offers some advantages over straight bonds to the investors:
- Investors face less risk of default than a straight bond
- Puttable bonds offer extra security and a safe exit option to the investors
- A Put option with bonds make them an attractive investment in secondary markets
- Investors may add certain clauses in bond indentures to exercise the put option after a certain period or for certain conditions
- The borrowers can acquire investments with lower coupon rates
- Borrowers may offer a bond Swap if the investors look for exercising the Put option
A Puttable bond offers an incentive to both investors and issuers. Although it offers low yields, it attracts investors due to the less risky nature of the investment. The bond indenture may include specific clauses of terms that bound investors to hold the bond for a specific period.
The issuers may offer a specific one-time window to investors to exercise the Put option or several dates before the maturity. The Put option is the only incentive that makes this type of bonds an attractive investment and to sell at a premium price.