What Is a Put Bond?
A put bond is a debt instrument that allows the bondholder to force the issuer to repurchase the security at specified dates before maturity. The repurchase price is set at the time of issue and is usually at par value (the face value of the bond).
- A put bond is a debt instrument with an embedded option that gives bondholders the right to demand early repayment of the principal from the issuer.
- The embedded put option acts an incentive for investors to buy a bond that has a lower return.
- The put option on the bond can be exercised upon the occurrence of specified events or conditions or at a certain time or times.
How a Put Bond Works
A bond is a debt instrument that makes periodic interest payments, known as coupons, to investors. When the bond matures, the investors or lenders receive their principal investment valued at par. It is cost-effective for bond issuers to issue bonds with lower yields as this reduces their cost of borrowing. However, to encourage investors to accept a lower yield on a bond, an issuer might embed options that are advantageous to bond investors. One type of bond that is favorable to investors is the put, or puttable, bond.
A put bond is a bond with an embedded put option, giving bondholders the right, but not the obligation, to demand early repayment of the principal from the issuer or a third party acting as an agent for the issuer. The put option on the bond can be exercised upon the occurrence of specified events or conditions or at a certain time or times prior to maturity. In effect, bondholders have the option of “putting” bonds back to the issuer either once during the lifetime of the bond (known as a one-time put bond) or on several different dates.
Bondholders can exercise their options if interest rate levels in the markets increase. As there is an inverse relationship between interest rates and bond prices, when interest rates increase, the value of a bond decreases to reflect the fact that there are bonds in the market with higher coupon rates than what the investor is holding. In other words, the future value of coupon rates becomes less valuable in a rising interest rate environment. Issuers are forced to repurchase the bonds at par, and investors use the proceeds to buy a similar bond offering a higher yield, a process known as bond swap.
Of course, the special advantages of put bonds mean that some yield must be sacrificed. Investors are wiling to accept a lower yield on a put bond than the yield on a straight bond because of the value added by the put option. Likewise, the price of a put bond is always higher than the price of a straight bond. While a put bond allows the investor to redeem a long-term bond before maturity, the yield generally equals the one on short-term rather than long-term securities.
A put bond can also be called a puttable bond or a retraction bond.
Special Considerations for Put Bonds
The terms governing a bond and the terms governing the embedded put option, such as the dates the option can be exercised, are specified in the bond indenture at time of issuance. The bond may have put protection associated with it, which details the period of time during which the bond cannot be “put” to the issuer.
Some types of put bonds include the multi maturity bond, option tender bond, and variable rate demand obligation (VRDO).