A bond may contain an embedded option; it may be like callable or putable etc.,
- Some bonds contain an embedded option, which gives the issuer the ability to repay the bond before the maturity date at specified times, known as call dates. In simple terms, a callable bond is bond in which the issuer has the right to call the bond away from the investors for a price determined at the time that the bond is issued. This amount will typically be greater than the principal amount of the bond.
- In case of callable bond, the individual with a long position in this security will essentially be long on the bond and short on the embedded call option.
- The call feature is positive for the issuer of the bond as it allows the issuer to essentially refinance debt at more favorable terms when interest rate falls.
- For the investor, on the other hand, this represents a drawback as it causes the price behavior of this security to exhibit negative convexity when interest rate level falls.
- This limits the capital appreciation potential of the bonds when interest rates fall.
- Investors are usually compensated for this drawback through a greater return potential as callable bonds are usually priced at a discount to other comparable non-callable fixed income securities.
- These bonds are referred to as callable bonds.
- A callable bond also called redeemable bond.
- A puttable bond, on the other hand, allows the investor to sell the bond back to the issuer, prior to maturity, at a price that is specified at the time that the bond is issued.
- Some bonds contain an embedded option, which enables the holder to force the issuer to repay the bond before the maturity date on specific times known as put dates. Bonds structured in this way are known as puttable.
- Puttable bond is also called as put bond, putable or retractable bond.
- The holder of a puttable bond is essentially long the bond and long the embedded put option.
- This has the effect of increasing the convexity of the price-yield relationship associated with this security and thus reduces the downside risk to the investor.
- This has the effect of increasing the price of the security and hence reducing the potential return to the investor.
When callable/puttable bonds are issued, the terms governing the bond (frequency, coupon, maturity), and the terms governing the embedded option such as the Strike schedule are defined. The embedded call/put option, on the other hand, may have a lockout period associated with It. (i.e. an initial period during which it cannot be called).
- A bond that can’t be called, or repaid, by the issuer before its maturity. The U.S Treasury is the most common issuer of non-callable bonds.
- The issuer of a non-callable bond subjects itself to interest rate risk because, at issuance, it locks in the interest rate and it will pay until the security matures.
- As a result, non-callable bonds tends to pay investors a lower interest rate than callable bonds.
- Some callable bonds are non-callable for a set period after they are first issued. The time period is called a protection period.
- A convertible bond has an embedded option that combines the steady cash flow of a bond, allowing the owner to call on demand the conversion of the bonds into shares of company stock at a predetermined price and time in the future.
- The bond holder benefits from this embedded conversion option, as the price of the bond has the potential to rise as the underlying stock rises.
- As we all know that for every upside, there is always a downside risk and so for convertible bonds, the price of the bond may also fall if the underlying stock does not perform well.