Bonds: Embedded Options

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Bonds also known as “Fixed Income Security” are financial instruments that help governments, companies or other issuer of the bond to borrow money from the market.  Bonds make a periodic stream of interest payments to investors while repaying the principal sum on a specified maturity date.

When we talk about bonds without any kind of contingency provisions; we think of either interest payments at regular interval or principal payback on the date of maturity, though valuations of a bond prior to date of maturity can be impacted by market interest rate; still more or less we talk about interest payment and principal amount.

What are Options: In general options are financial instruments, which offer the buyer of the contract a right but not the obligation to buy or sell the underlying security.

Embedded Options in Bonds: Embedded options in bonds also referred as “Contingency Provisions” is a clause in the legal document signed between issuer of the bond and the investor; as per which either party is allowed to take certain actions incase an event occurs e.g. market interest rate goes down or share price of the company issuing bond goes up.

Unlike a bare options which can be traded in the security market; an embedded option is inseparable from the bond and cannot be traded in security market but embedded option can impact the price of the bond.

Few of the most common bonds with embedded options are: Callable bond, Puttable bond and Convertible bond.

Callable Bond: One of the most common embedded options is call option. A callable bond gives issuer of the bond the right but not the obligation to redeem all or certain part of the issued bond before the date of maturity at a predetermined price.

Issuer of the bond (Government, Corporations or private companies) choose to issue callable bond rather than issuing non-callable bonds to take the advantage of the falling market interest rate or improvement in the credit rating. If market interest rates falls or credit rating improves; then issuer of the bond can borrow money from the market at lower interest rate; accordingly issuer of the bond will replace old and costlier bond with new and cheaper bond (As earlier bonds were issued either at high discount or higher Coupon payment).

For example, assume that at the time of issuance of the bond; the market interest rate was 7% and that a company issued a bond with a coupon rate of 8%. Now if market interest rate goes down to 4% then company can issue new bonds with coupon rate of 5%.

As we understood, callable bonds gives the issuer of the bond an advantage to call the bonds incase market interest rate goes down which left investor in a position of disadvantage; as investor now can invest only at lower interest as overall market interest rate has come down. To compensate this disadvantage; callable bonds are issued at deep discount or higher coupon rate.

Price of callable bonds is lower than price of straight bonds.

Price of callable bond = price of straight bond – price of call option

 

Puttable bonds: A put option gives the investor or holder of the bond a right but not the obligation to sell the bond back to the issuer at a predetermined price on specific dates. On the contrary to Callable bond; Puttable bonds are beneficial for the investor as puttable bonds guarantees a pre-determined price at redemption dates. Puttable bonds; gives investor a chance to take advantage of increase in the market interest rate or decrease in the credit rating of the issuer.

For example, assume that at the time of issuance of the bond; the market interest rate was 4% and that a company issued a bond with a coupon rate of 5%. Now if market interest rate goes up to 7% then company has to issue new bonds with coupon rate of 8%; thus puttable bonds give opportunity to investor to sell the low coupon rate bonds and buy bonds with higher coupon rate or at higher discount.

As illustrated, puttable bonds gives the investors an advantage to sell the bonds back to issuer  incase market interest rate goes up which left issuer of the bond in a position of disadvantage; as issuer of the bond has either to give higher coupon rate or sell the bond at deep discount. In both the cases cost of raising funds goes up.  To compensate this disadvantage to the issuer; puttable bonds are issued either at premium or lower coupon rate.

Price of puttable bonds is higher than price of straight bonds.

Price of puttable bond = price of straight bond + price of put option

Convertible bonds: A convertible bond is a hybrid security with both debt and equity features. It gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing company. Thus, a convertible bond can be viewed as the combination of a straight bond (option-free bond) plus an embedded equity call option.

Convertible bond has an advantage for investors; as investors have an option to replace bond with specified numbers of shares in case there is a price appreciation. Convertible bonds also give downside protection for the investors as share price depreciation has no impact on the interest payment for the bond holder.

The option to convert bonds into specified number of shares gives an advantage to the investors thus; convertible bonds are priced higher than non-convertible bonds.  Similarly, the yield on a convertible bond is lower than the yield on an otherwise similar non-convertible bond.

From the perspective of issuers; convertible bonds offers two advantages. First convertible bonds are issued at lower coupon rates and second debt elimination in case bonds are redeemed.

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