Contingency Provisions

Contingency provisions allow for some conditional actions. They grant the issuer and/or the bondholder rights but no obligations to exercise specified actions. Types of bonds with embedded options are callable, putable, and convertible bonds.

Callable Bonds

Callable bonds give the issuer the right to redeem the bond before maturity, thereby providing protection against a decline in interest rates. Therefore, the issuer of a callable bond has the right to replace an old, expensive bond. From the investor’s perspective, however, there is a higher level of reinvestment risk. Therefore, callable bonds usually offer a higher yield.

A call premium is paid over and above par if a bond is called. The call protection period prohibits calling a bond prematurely and incentivizes the investor to buy it. Make-whole calls make a payment based on the present value of the future coupon and principal at an early date. Thus, the redemption value is significantly higher than the current market price. American-style calls or continuously callable bonds provide the right to call a bond at any time. European-style calls give the right to call only once at the call date. Bermuda-style calls give the right to call on specified dates after the call protection period.

Putable Bonds

A put provision gives bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates. If interest rates rise, the bondholders can put the bond back and get cash to reinvest in higher-yield bonds. As a result, the price of a putable bond is usually higher than that of a regular bond. As we have seen in the previous section, a European-style put is a one-time putable bond, whereas multiple sell backs are possible in Bermuda-style puts.

Convertible Bonds

A convertible bond is a hybrid of both debt and equity features. It gives a bondholder the right to exchange the bond for a specified number of common shares. Because of this feature, the price of a convertible bond is usually higher.

Alternatively, a warrant could be attached to a bond. A warrant is not an embedded option but rather an “attached” option that is valued separately from an accounting perspective. As such, a warrant can be separated from the bond, and someone else could use it. Warrants are frequently attached to bonds as a “sweetener.”

Question

Which of the following bonds with an embedded option would most likely sell at a higher price than an otherwise similar bond?

1. A putable bond.
2. A callable bond.
3. A make-whole callable bond.

Solution

The correct answer is A.

If interest rates rise, the bondholder can put the bond back and get cash to reinvest in higher yield bonds. Therefore, the price of a putable bond is usually higher.