What are callable bonds? What are puttable bonds?

When we are exploring the world of bonds, we might come across terms like "callable bonds” and “puttable bonds”. But what exactly are callable and puttable bonds, and how do they work? Let us explain in layman's terms.

What is a callable bond?

A callable bond, also known as a redeemable bond, is a type of bond that gives the issuer the option to pay it off before its official maturity date. It's like having the ability to pay off a loan early but in the world of bonds.

What's in it for investors?

Callable bonds usually come with a sweetener to make them attractive. They typically offer a higher interest rate, also known as a coupon rate, compared to non-callable bonds.

The interest rates are higher because investors are taking on a bit of risk. Since the issuer can potentially "call back" the bond early, investors want a better reward for that risk. So, you get a more appealing interest rate, which can be a win for your investment portfolio.

In a nutshell, callable bonds give companies financial flexibility and investors the chance to earn a better return, but they also come with some risks. It's essential to weigh these pros and cons and understand the terms before diving into callable bonds.

An example of a callable bond.

Company ‘A’ issued a callable bond on October 1, 2016, with an interest rate of 10% p.a. maturing on September 30, 2021. The amount of the issue is 100 crores. The bond is callable and subject to 30 days’ notice, and the call provision is as follows.

In simple terms, this means Company 'A' can choose to pay off the bonds early, but they have to pay a bit more than the original value to do it. The initial call premium is higher at 5% of the face value, and it gradually reduces to 2% with time.

So, for investors, it's essential to understand that while they might get their investment back before the maturity date, the call provision could affect how much they receive.

Callable bonds can be a win-win for both companies and investors, offering flexibility for the issuer and potentially higher returns for the investor. However, it's crucial to consider the terms and how they might impact your investment strategy before diving in.

What is a puttable bond?

A put bond is a unique type of debt instrument. What sets it apart is the bondholder's special power—it allows them to demand the issuer repurchase the bond before its maturity date. In essence, it's like having an "early exit" button for your investment.

Example of Puttable Bond

price of the putable bonds=price of conventional bonds+value of the put option

In the following example, the puttable bond's price is Rs. 90, and it was initially issued at low-interest rates. Notably, when interest rates rise, the yield to maturity (YTM) for a non-puttable (straight) bond with identical terms reaches 10%.

As this is a puttable bond, the investor can sell it at a predetermined price. To decide what to do, the investor calculates the value of a comparable non-callable bond. Using a yield to maturity (YTM) of 10%, the investor finds the non-callable bond's value to be Rs. 81, helping them make an informed choice.

Here, the investor can sell these bonds for Rs. 90 and purchase similar bonds, except they can't be sold early, for Rs. 81. A wise investor would opt for early repayment since Rs. 90 is greater than Rs. 81, making it a logical choice

Key Takeaways for Callable Bonds:

• Callable bonds give issuers the option to repay the bond early, potentially when interest rates drop.

• Investors in callable bonds may receive higher coupon rates as compensation for the call risk.

• Callable bonds can limit potential returns for investors if the bonds are called before maturity.

• The call option on a callable bond is at the issuer's discretion, not the investor's.

• Investors should carefully assess the call provisions and potential impact on their investment strategy.

Key Takeaways for Puttable Bonds:

• Puttable bonds grant bondholders the right to sell the bond back to the issuer before maturity.

• These bonds provide investors with an exit strategy, enhancing flexibility.

• Puttable bonds can be appealing for risk-averse investors seeking liquidity options.

• The repurchase price for puttable bonds is typically set at the bond's face value.

• Understanding the conditions and timing for exercising the put option is crucial for investors.

Difference between Callable bond and puttable bond

A callable bond allows the issuer to repay it early, while a puttable bond permits the bondholder to sell it back before maturity. Callable bonds benefit issuers, while puttable bonds offer flexibility to bondholders.

Frequently Asked Questions (FAQs):

1. What is a callable bond?

A callable bond allows the issuer to repay the bond early, often when interest rates decline.

2. Why do callable bonds offer higher coupon rates?

To compensate investors for the risk of having their bonds called before maturity.

3. Can investors control when a callable bond is called?

No, the call option is at the discretion of the issuer.

4. What is a puttable bond?

A puttable bond grants bondholders the right to sell it back to the issuer before maturity.

5. What's the advantage of puttable bonds for investors?

Puttable bonds offer an exit strategy and flexibility for investors, especially those seeking liquidity options.