Contingency provisions allow for some conditional action. They provide the issuer and/or the bondholder rights but no obligations to exercise some specified action. Types of bonds with embedded options are callable, putable, and convertible bonds.
Callable bonds give the issuer the right to redeem the bond before maturity, 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. Callable bonds usually offer a higher yield.
A call premium is paid over and above par if the bond is called. The call protection period prohibits calling a bond early and is an incentive for 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. The redemption value is significantly greater 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.
A put gives the 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. The price of a putable bond is usually higher. As we have seen in the previous section, a European-style put is a one-time puttable bond whereas multiple sell backs are possible given Bermuda-style puts.
A convertible bond is a hybrid of both debt and equity features. It gives 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 the 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.”
Which of the following bonds with an embedded option would most likely sell at a higher price than an otherwise similar bond?
A. A putable bond
B. A callable bond
C. A make-whole callable bond
The correct answer is A.
If interest rates rise, the bondholders can put the bond back and get cash to reinvest in higher yield bonds. Therefore, the price of a putable bond is usually higher.
Reading 42 LOS 42f:
Describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and identify whether such provisions benefit the borrower or the lender