What is a Putable Bond?

A putable bond is also known as a put bond or a retractable bond. It is a debt instrument that allows an investor to sell back an issuer on the bond before it matures but does not have the obligation to do the selling. In editorials, it's often called a bond with an embedded put option to allow an owner to force early redemption. It is the opposite of a callable bond, wherein the issuer has the option to redeem a bond prior to its maturity.

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How do putable bonds work?

A bond is a debt instrument that generates interest periodically, which is referred to as coupons, in return for compensating investors. At maturity, the investors get their principal investment at par value. Most issuers strive to issue bonds at the lowest possible yields to minimize their borrowing costs. In order to allure investors to accept such lower yields, there can be embedded options that benefit the bondholders. One such investor-friendly bond is the putable bond.

A put bond is an investment instrument that allows a holder to demand that the issuer, under certain conditions or at specified times prior to maturity, repay principal, although it does not create an obligation on the holder's part. Essentially, an option is given to the bondholders to "put" the bonds back to the issuer either once during the life of the bond—as in a one-time put bond—or on multiples of specified dates.

For instance, bondholders can exercise the option in times of a rise in the market interest rates. An increase in interest rates moves with the price of a bond in the other direction. As compared to the existing bonds, newer bonds that are being issued in the market offer a higher coupon rate and hence move against the already issued bonds. Thus, the coupon payments occurring in the future become less valuable in a rising rate environment. In such cases, the issuer has the obligation to repurchase the bonds at par, after which investors can then invest in other bonds yielding better; this move is referred to as a bond swap.

Clearly, there is no free lunch to put bonds. It implies that upon the offering of a put option bond, investors would accept a lower promised yield as compared to that of an equivalent straight bond due to the intrinsic value gained via attaching the put option onto the bond. As such, a put bond price is always higher in comparison to a straight bond. Put bonds allow redemption of a long-term bond before maturity, but the yield in such bonds would be more commensurate with short-term securities than with long-term ones.

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How to find the value of a putable bond?

Valuing putable bonds is more complex than valuing plain-vanilla bonds due to the embedded put option. This option, which allows investors to require the issuer to redeem the bonds early, directly impacts the bond's price.

The fair market price of a putable bond can be determined using the following formula:

Putable Bond Price = Price (Plain-Vanilla Bond) + Price (Put Option)

Where:

• Price (Plain-Vanilla Bond) is the price of a comparable bond without any embedded options, sharing similar characteristics with the putable bond.
• Price (Put Option) is the value of the embedded option that allows early redemption before maturity.

This formula accounts for both the value of the underlying bond and the additional value provided by the put option.

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Characteristics of Putable Bonds

The important distinguishing features of putable bonds from other debt securities are as follows:

Put Option: A put option is embedded in the bond that gives its holder the right, but not the obligation, to sell the bond back to the issuer before its maturity at a predetermined price.

Coupon Rate: Like all other debt instruments, putable bonds also pay interest to bondholders at certain periodic intervals. There is, however, a fixed rate of interest that gets determined at issuance.

Maturity Date: The maturity date is the date by which the principal has to be redeemed in full subject to the bondholder not exercising this option of the put.

Put Dates: Putable bonds have specific dates on which the holder can practice the put option. These are clearly spelt out in the contractual agreement of the bond.

Put Price: The par value is normally the issue price for a putable bond. Nevertheless, the price of the bond may vary with the interest rate and other exogenous variables in the secondary market.

Lower Yield: Additional flexibility and hedge against rising interest rates that the put option provides come at the cost of a lower yield, relative to comparable bonds without the embedded option.

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Types of Putable Bonds

Multi-maturity bonds: In this bond structure, there are multiple dates of maturity for exercising the put option at different stages in the life of the bond. This feature provides flexibility to the bondholders to adjust with the dynamic conditions prevailing in the market.

Option tender bonds: These are floating-rate bonds secured by municipal or tax-exempt bonds that give bondholders the right to demand that the issuer repurchase their bonds prior to maturity at par value. This will come at the expense of giving up all future interest payments in return for the security of being able to redeem the bond early.

VRDOs: Very similar to puttable bonds, VRDOs are very close to the previous in that they carry an interest rate that is reset in the current market. Investors can demand redemption of their principal at any time; hence, these long-term municipal bonds are flexible and interest rate responsive.

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Advantages and Disadvantages of Putable Bonds

Advantages 

• Interest Rate Risk Mitigation: Safeguards against rising interest rates.
• Liquidity: Enhanced liquidity due to the ability to sell the bond back to the issuer.
• Flexibility: Offers the option to exit the investment before maturity.
• Credit Risk Protection: Shields against potential credit deterioration of the issuer.
• Predictable Returns: Guarantees a minimum return if the put option is exercised.

Disadvantages:

• Complexity: More complex to value and understand compared to other bonds.
• Limited Upside Potential: May miss out on higher yields if interest rates decline.
• Cost to Issuers: More expensive for issuers due to the possibility of having to repurchase the bonds.

In conclusion, putable bonds offer a unique blend of flexibility and security, making them an attractive option for investors seeking to mitigate interest rate risks and maintain liquidity. With the ability to sell the bond back to the issuer before maturity, these bonds provide a valuable safety net in fluctuating market conditions. However, this added protection comes with trade-offs, including lower yields and greater complexity compared to standard bonds.

For investors looking to balance safety with higher returns, exploring alternative investment options such as Compound Real Estate Bonds could be worthwhile. These bonds offer an 8.5% APY and feature benefits like auto-investing, combining the security of fixed income with the potential for greater growth. By diversifying your portfolio with both putable bonds and high-yield investments like Compound Real Estate Bonds, you can optimize your financial strategy for both stability and enhanced returns.

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