What it means
A normal bond locks the investor in until maturity unless they sell it in the market. If interest rates rise, the bond's market price falls, and the investor must accept a loss to get out.
A put bond avoids that problem, because the investor can hand it back to the issuer on specified dates and receive a fixed price, usually its face value. This right is called a put option and it is built into the bond.
It works like an insurance policy for the investor. If conditions deteriorate, the investor can exercise the option and recover the principal.
Because the feature favours the investor, it has a cost. The issuer pays a lower coupon (the regular interest payment) than it would on a plain bond, or the buyer pays a higher price.
The value of a put bond is roughly the value of a plain bond plus the value of the put option. Issuers use put bonds when they want to borrow more cheaply or attract investors who are cautious about the credit quality of the company.
The trade-off is that the issuer must be ready to repay early. If many investors exercise at the same time, the issuer may need to refinance quickly, which is a liquidity risk.
Investors tend to exercise the option when market interest rates are higher than the bond's coupon, because they can then reinvest the money at better rates. When rates are low, the bond is more valuable to keep.
This is the opposite of a callable bond, where the issuer holds the early repayment right and uses it when rates fall. A nuance is that put dates are specific.
Some bonds can be put only once, some on a series of dates, and some only after a defined event such as a change of control or a credit rating downgrade. Reading the terms is essential, because a right that cannot be used when you need it has little value.
In practice
Real-world examples.
Example
A utility company issues a ten-year put bond that investors can sell back at face value after five years. An investor buys $100,000 of it. When rates rise sharply in year five, the investor exercises the put and reinvests the $100,000 at the higher rate.
Example
A mid-sized retailer with a weaker credit rating wants to borrow at a reasonable cost. By including a put feature that triggers if its rating is cut, it persuades cautious institutions to buy. The coupon is 0.5% lower than it would have been on a standard bond.
Example
A city government issues putable bonds to fund a hospital. Investors may sell them back every year at face value. The finance office keeps a liquidity reserve, because a wave of exercises in a tough market would require quick access to cash.
Formula
Calculation
Value of a put bond = value of a straight bond + value of the put option
Suppose a straight bond with the same coupon, maturity and credit quality is worth $960 per $1,000 of face value. The embedded put option, which lets the holder sell back at $1,000, is estimated to be worth $25. The put bond is therefore worth 960 + 25 = $985. The extra $25 is the price of the right to recover $1,000 on the put date, whatever the plain bond is worth in the market by then.Case study
Seen in the real world.
Northgate Telecom is an illustrative, fictional company that needed to borrow $50,000,000 for a network upgrade. Its credit rating was borderline, and investors asked for a high interest rate on ordinary bonds. The treasurer proposed a put bond with a put date after four years at face value.
Because investors gained a safety valve, they accepted a coupon of 5.0% instead of the 6.0% required on the plain bond. The saving was 1% on $50,000,000, or $500,000 a year in interest. The company set aside a liquidity facility so that it could repay quickly if the put were exercised.
In year four, interest rates had risen and about 60% of the investors exercised the option. Northgate repaid $30,000,000 using its facility and refinanced. The illustrative lesson was that the cheaper coupon came with a real obligation to find cash when investors decided to leave.
Watch out
Common mistakes.
- Assuming a put bond is always better for the investor, when the lower coupon is the price paid for the protection.
- Ignoring the issuer's ability to repay if the put is exercised, which turns the option's value into credit risk on the issuer.
- Confusing a put bond with a callable bond, when the putable bond gives the early repayment right to the investor and the callable bond gives it to the issuer.
Questions
People also ask.
When do investors usually exercise the put?
Typically when market interest rates are above the bond's coupon or when the issuer's credit quality worsens, since recovering face value then beats holding.
Is a put bond more expensive than a plain bond?
Yes, usually, because the put option has value to the investor, and this shows up as a higher price or a lower yield.
What risk does the issuer take on?
The issuer carries refinancing and liquidity risk, because it may have to find cash at short notice if many investors exercise.
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