Bonds that have a put option can be sold back to their issuers before their respective maturity dates. These bonds are called puttable bonds or put bonds, and they represent one of the different types of bonds categorized according to their embedded option.
A put option specifically grants the bondholder the right, but not the obligation, to sell the bond back to the issuer before its maturity date at a predetermined price and time, regardless of the reason. This article describes the pros and cons of puttable bonds.
Pros: Advantages of Puttable Bonds
Investing in puttable bonds might be an ideal option for investors who are looking for an investment vehicle that balances security and flexibility. These bonds are ideal for those who want to have the option to sell their bonds back to the issuer before the maturity date if market conditions change or if they need access to their funds.
Puttable bonds offer investors a higher degree of flexibility compared to non-puttable bonds and callable bonds. These bonds are more liquid but can still provide modest investment returns. This makes them suitable for investors with short-term to medium-term investment horizons. The following are the specific advantages of puttable bonds:
• Flexible Investment: The put option grants the bondholders the right, but not the obligation, to sell their puttable bonds back to their respective issuers. This means that investing and holding puttable bonds give investors the option to access their investment capital if needed or if the need for liquidity arises.
• Higher Liquidity: Bonds are more liquid than stocks but not as liquid as money market instruments. Nevertheless, because of the embedded put option, another advantage of puttable bonds is that they have higher liquidity than callable bonds and traditional bonds with medium-term to long-term maturity dates.
• Risk Reduction: These bonds are suitable for investors with moderate to conservative risk profiles. The put option provides bondholders with some level of protection against interest rate risk and credit or default risk. These investors can sell their bonds back to their issuers once they get wind of interest and credit issues.
• Inherent Price Floor: Puttable bonds also contain an inherent price floor. This means that the market price of these bonds will not fall below a certain level. The price floor makes these bonds a safer bet than stocks and even high-yield bonds while also ensuring that the invested capital would not be reduced to zero.
• Portfolio Diversification: Another advantage of investing in these bonds is diversification. Adding puttable bonds in a portfolio can ease out the risk from other aggressive investments while also building further fixed-income assets. Bonds are suitable for income-seeking investors.
Cons: Disadvantages of Puttable Bonds
Investing in bonds often results in lower capital gains or investment returns compared to stocks. Bonds also have risks. Nevertheless, considering that there are different types of bonds, the level of gains and risks can vary. Puttable bonds may offer lower returns compared to callable bonds, and they are also exposed to higher liquidity risk and default risk.
Those who seek a higher passive income from coupons and better returns from yields may find puttable bonds unsuitable to their investment goals and objectives. These bonds are also not ideal for investors with long-term investment horizons and who do not prioritize liquidity. The following are the specific disadvantages of puttable bonds:
• Lower Investment Returns: One of the main disadvantages of puttable bonds is that they tend to have lower coupons and yields than traditional bonds and callable bonds. This makes them unideal for investors seeking to maximize their investment returns or looking for substantial capital appreciation.
• Higher Investment Cost: These bonds are also more expensive than traditional bonds and callable bonds. Their prices are higher than the price of a straight bond because the put option adds value to an investor. Issuers of these bonds tend to charge more to compensate for the risks of embedding a put option.
• Liquidity and Default Risks: Holding puttable bonds can still expose investors to higher liquidity and credit or default risks. Remember that bondholders have the right to sell these bonds back to their issuers but this is not guaranteed. An issuer needs to have enough funds to redeem their puttable bonds back from their bondholders.
• Unguaranteed Put Option: It is also important to reiterate the fact that the put option is not guaranteed. An issuer with struggling finances might end up not having enough cash to redeem its puttable bonds. The put option becomes worthless in this case, and the bondholder would not be able to liquidate their investments.
• Valuation Can Be Complex: The valuation of a particular puttable bond can be complex because the put option creates uncertainties about the cash flows that the investor will receive from the bond. It would also require option pricing models such as the binomial model or the Black-Scholes model for valuation.
