Understanding Bond Options: Callable, Puttable, and Convertible Bonds
Newsletter #53
In this article we shall walk through the three main bond options:
Callable
Puttable
Covertible
1. Callable Bonds: The Issuer’s Option to Buy Back Early
What is a Callable Bond?
A callable bond gives the issuer (the company or government that issued the bond) the right, but not the obligation, to redeem the bond before its maturity date, at a predefined price called the call price.
Why Would an Issuer Call a Bond?
Issuers call bonds to take advantage of falling interest rates. For example, if a company issued bonds at 6% interest but now rates have dropped to 4%, they might want to buy back the old bonds early and reissue new bonds at the lower rate, reducing their interest expenses.
Pros and Cons for Investors
Pros: Callable bonds often offer a higher interest rate (coupon) compared to non-callable bonds to compensate investors for the call risk.
Cons: Investors face reinvestment risk - if the bond is called, they get their principal back but may have to reinvest it at lower prevailing rates.
Example
Imagine a 10-year bond callable after 5 years. If interest rates drop in year 6, the issuer might call the bond, paying investors back early and issuing cheaper debt.
2. Puttable Bonds: The Investor’s Option to Sell Early
What is a Puttable Bond?
A puttable bond gives the investor the right to sell the bond back to the issuer before maturity, usually at par value or a predetermined price.
Why Would Investors Want This?
Puttable bonds protect investors against rising interest rates or credit deterioration. If rates rise or the issuer’s credit weakens, investors can sell the bond back to the issuer and reclaim their principal.
Pros and Cons for Investors
Pros: Offers downside protection and flexibility, reducing interest rate and credit risks.
Cons: Because of the added protection, puttable bonds usually have a lower yield than comparable plain vanilla bonds.
Example
If you buy a 10-year puttable bond with a 5-year put option and rates rise sharply in year 4, you can sell the bond back to the issuer and reinvest at higher rates.
3. Convertible Bonds: The Option to Turn Debt into Equity
What is a Convertible Bond?
A convertible bond lets investors convert their bonds into a predetermined number of shares of the issuing company’s stock. This option is usually exercisable after a certain date and until maturity.
Why Are Convertible Bonds Attractive?
They offer a hybrid investment: fixed income with the potential upside of equity. If the company’s stock price rises significantly, investors can convert and participate in the equity gains. If the stock doesn’t perform, they still earn bond interest and get their principal back at maturity.
Pros and Cons for Investors
Pros: Potential for equity upside with downside protection from the bond’s fixed income feature.
Cons: Convertible bonds often pay lower interest rates because of the conversion option’s value.
Example
Suppose a company issues a convertible bond with a conversion price of $50 per share. If the stock rises to $70, investors might convert bonds into shares, benefiting from the price increase.
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