Fixed Income Securities with Embedded Options

Embedded options give either the issuer of a bond or the bondholder the right to take advantage of movements in interest rates. Embedded options are attached to a straight (option-free) bond. This makes them bond-dependent, and hence they cannot be stripped and traded separately.

Simple Embedded Option Structures

Call Options

A callable bond includes an embedded call option. It can be redeemed before maturity at the discretion of the issuer. Additionally, it has a lockout period, a period during which the issuer cannot call the bond.

Callable bonds can either be:

• European: Exercised only at maturity.
• American: Can be exercised at any time up to and including maturity.
• Bermudan-style: An exotic option that is only exercised at predetermined dates.

Put Options

A putable bond includes an embedded put option. The put option gives the bondholder the right to put the bond back to the issuer at par before expiration. Similar to the case of a call option, a put option has a lockout period, a period during which the bondholder cannot put back the bond.

Putable bonds are mostly European, but they can also be Bermudan. However, there are no American putable bonds.

An extension option has the same structure as a put option. However, it allows the bondholder to extend the bond’s maturity.

Complex Embedded Options

Complex embedded bonds include those with other types of options or a combination of options. They include:

• Convertible bond: This is a bond that has a conversion option that allows the bondholders to convert their holding into the issuer’s common stock.
• Callable + putable bond: This one comes with both a call option and a put. 
• Estate put (death put): This is a bond that can be put in the event of the holder’s death. This is usually done by the appointed heirs.
• Sinking fund bond:  In this one, the issuer gradually sets funds aside in order to retire the issue, thus reducing credit risk. It is often callable and may have a delivery option

Question

An embedded option that allows the bondholder to extend the maturity of a bond is best known as a (an):

1. Extension options.
2. Bermudan style call option.
3. Estate put.

Solution

The correct answer is A.

An embedded option resembles a put option. At maturity, the holder of an extendible bond has the right to keep the bond for several years after maturity, potentially with a different coupon.

B is incorrect. A Bermudan-style call option can be exercised only on a predetermined schedule of dates after the end of the lockout period specified in the bond’s indenture.

C is incorrect. An estate put (“death put”) option can be redeemed at par by the deceased bondholder’s heir.

Reading 30: Valuation and Analysis of Bonds with Embedded Options

LOS 30 (a) Describe fixed-income securities with embedded options.