You always thought call and put options were linked to equities and indices right? So you are surely surprised to hear about call and put options on bonds. As you are aware a bond or debenture is a fixed return instrument which pays regular interest and then redeems the principle at the end of the tenure of the bond. You know about differences between call options and put options in indices and equity trading; but what is meant by call and options on bonds? Is this the same as buying put options and writing call options on equities and indices? There is a slight difference when it comes to bonds.
Understanding all about embedded bonds
An embedded bond is a bond that is embedded with the option that can either be a call option or a put option. Such bonds are popularly referred to as callable bonds or puttable bonds. What is a callable bond? A callable bond is bond in which the issuer has the right to call the bond away from the investor 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. For example, a 15 year bond paying 12% interest may have a call option where the issuer can call back the bond at the end of 5 years at a set price. Suppose, after the bond is issued, say the interest rates in the market fall from 12% to 7%. There is no reason the company will continue to service debt at 12% when it can raise fresh funds at 7%. So the company will exercise the call option at the end of 5 years, redeem the bond and raise money through fresh issue of bonds at much lower interest rates.
A puttable bond, 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. The call feature is positive for the issuer of the bond as it allows the issuer to refinance debt at more favourable terms when interest rates fall. But, then what about the investors? For the investor, this represents a challenge as he will have to now reduce his earnings expectation from the bonds. Therefore investors are compensated for this drawback through an embedded put option. 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. What happens when the investor holds a put option? Say the bond is currently paying 7% and rates in the market have gone up to 11%. The bond investors realizes that he is losing out as he earning lower returns and can actually earn 400 bps more in the market. So he will exercise his put option, get the bond redeemed and deploy the funds at the prevailing rate of 11%.
That is why it is said that you must read the fine print of the bond agreement. The agreement will specific if there is any call option and put option on the bond. Such bonds are called embedded bonds since the call and/or put option are embedded in the bond at the time of issue itself along with the terms and conditions clearly laid out. 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. Normally, embedded call/put option have a lockout period associated with it (i.e. an initial period during which it cannot be called).
The famous case of IDBI millionaire bonds
When IDBI raised deep discount bonds in 1996 with maturity of 25 years at 16%, there were many elated investors. They had locked in their funds at 16%. What they missed was the call option at the end of 5 years. By 2001, the interest rates had come down by nearly 600-700 basis points and IDBI did the normal and logical thing of just calling back these bonds as they could now borrow at much lower rates. That left a lot of long term dreams of investors in the lurch. So, be extremely cautious about long term bonds as they are most likely to have an embedded option for the issuer.