What are callable and putable bonds, and how do they function? - Trading Class | Trading Courses | Webinars
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What are callable and putable bonds, and how do they function?

Understanding Callable and Putable Bonds

When considering bond investments, two terms you will likely encounter are ‘callable’ and ‘putable’ bonds. These terms refer to specific provisions that a bond may carry, granting special rights to either the issuer or holder. It is essential to understand these concepts as they can significantly impact a bond’s yield, risk profile, and investment attractiveness.

What are Callable Bonds?

A callable bond (also known as a redeemable bond) gives the bond issuer the right but not the obligation to redeem the bond before its maturity date. In simpler terms, it allows the issuer to ‘call’ back the bond from investors at a predetermined price, known as the ‘call price’.

The issuer would typically choose to exercise this right when the interest rates in the market drop significantly below the coupon rate of the bond. By redeeming the bond early, the issuer can reissue new bonds at lower interest rates, reducing their debt servicing costs.

How do Callable Bonds Function?

Each callable bond comes with a specific call date and call price detailed in its bond indenture. The call date is when the issuer can first choose to call the bonds, while the call price is usually set at par or slightly above it. Some callable bonds come with call protection, a period where the issuer cannot exercise the call option.

When a callable bond is called, the bondholder receives the call price and any remaining interest up to the call date. After a bond is called, it ceases to exist; the investor no longer receives interest payments, and the issuer has no further obligations to the bondholder.

The allure of callable bonds to investors largely depends on the prevailing economic climate and personal risk tolerance. They tend to carry higher coupon rates than non-callable bonds, providing a higher yield to compensate for the call risk. The fact that a callable bond has a call option, however, limits its potential for appreciation in an environment of declining interest rates.

What are Putable Bonds?

On the opposite side of the spectrum are putable bonds. These provide the bondholder (investor) with the right, but not the obligation, to sell the bond back to the issuer at a predetermined price before its maturity date. Essentially, it gives the bondholder an ‘exit route’ during periods of rising interest rates or financial distress of the issuer.

How do Putable Bonds Function?

Like callable bonds, putable bonds have specific ‘put’ dates and prices outlined in their bond indenture. The put price is generally at par value or slightly above it. If interest rates rise or if there are concerns about the issuer’s creditworthiness, the bondholder can ‘put’ the bond back to the issuer, receiving the put price and any accrued interest up to the put date.

Putable bonds tend to offer lower coupon rates than non-putable bonds, reflecting the reduced risk to the bondholder. However, in a rising rate environment or during periods of issuer risk, the put option adds value to the bondholder as it provides a form of capital protection.

Bond Strategy and Risk Considerations

The existence of call or put provisions should factor into your overall bond investment strategy. With callable bonds, always factor call risk into your yield calculations, especially in a declining interest rate environment. As a callable bond holder, avoid the ‘reinvestment risk’, which occurs when your called bond is reinvested in a new bond issuing lower interest.

For putable bonds, consider the yield to put—the total return on the bond if it is put back to the issuer at the first put date—as part of your assessment. Also, watch for signs of issuer distress, where the put option can serve as a safety net.

Final Note

Callable and putable bonds offer unique features that can enhance the flexibility and potential returns of your bond portfolio. However, they also introduce additional risks and considerations vis-à-vis traditional bonds. As always, thorough research, careful assessment, and prudent risk management are paramount when investing in these complex securities. Your financial objectives, risk tolerance, and market trends should all be considered when making bond investments. Having a thorough understanding of bond basics and strategies from a professional advisor or bond market expert is key to successfully navigating the bond marketplace.