Beginner's guide to callable and puttable bonds

Beginner's guide to callable and puttable bonds

Bonds are fixed-income investment instruments issued by governments, companies, and other entities to raise capital. The issuer promises to pay periodic interest (coupon) and repay the principal amount on maturity. Most bonds follow a straightforward structure – The issuer raises capital by selling bonds to investors, pays coupons over the bond's tenure, and repays the principal amount on maturity.

However, some bonds have special features that give the issuer or investors certain additional rights. Two such bonds are callable bonds and puttable bonds. In callable bonds, the issuer has the right to redeem or 'call back' the bond before maturity. In puttable bonds, the investor has the right to demand early repayment or 'put back' the bond.

Understanding callable and puttable bonds is important for investors looking to add fixed-income products to their portfolio. Corporates and government entities frequently issue these instruments to optimise their capital structure.

What are callable bonds?

A callable bond is a type of debt instrument that gives the issuer (borrower) the right to redeem or repay the bond before its maturity date. The issuer can exercise the right to 'call back' bonds either at predetermined call dates or anytime during the bond's life.

For instance, a 5-year callable bond may have call dates at the end of years 2 and 3. The issuer can choose to repay the bond on those dates rather than waiting until maturity at year 5. Alternatively, some callable bonds are continuously callable, allowing the issuer to call back at any time.

When the issuer calls a bond, the investor who holds the bond gets their principal repaid similar to a maturity event. In essence, the callable feature shortens the bond's duration because the issuer can repay before the stated maturity date.

Why do issuers issue callable bonds?

Callable bonds provide issuers with flexibility in managing their long-term debt. With callable bonds, issuers can refinance debt if market interest rates decline. They can call old bonds with high coupons and issue new ones at lower rates to reduce interest costs. Callable bonds also help issuers align cash flows with specific projects, such as infrastructure assets, by calling back bonds when the project ends.

Additionally, callable bonds enable issuers to manage credit risk perceptions. If an issuer's credit quality improves, it can call existing bonds and issue new ones at better terms, signalling improved creditworthiness.

In India, callable bonds are issued by public sector undertakings (PSUs), infrastructure and construction firms, non-banking financial companies (NBFCs), and banks. Government bonds, however, are generally not issued with call features.

Callable bond pricing and yields

To compensate for the additional redemption risk in callable bonds, issuers have to offer higher yields than comparable non-callable bonds. Investors face reinvestment risk if the bond gets called before maturity, which is why callable bonds offer a yield premium.

The higher yield offered for a callable bond compared to a non-callable bond is called the call premium. For example, if 5-year government bonds yield 6% and a 5-year callable PSU bond yields 7%, the call premium is 1%. The call premium is generally higher for longer maturities and for issuers with a higher perceived likelihood of calling the bond.

In addition to the coupon, the price and yield of a callable bond factor in the value of the embedded call option. If interest rates fall, the likelihood of the bond being called increases, which lowers its price and increases its yield to maturity. This means callable bond prices tend to be more volatile than non-callable bonds.

Investor considerations for callable bonds

Investors should carefully evaluate the reinvestment risk of callable bonds, especially in falling interest rate scenarios. They need to assess the adequacy of the call premium relative to the reinvestment risk and analyse the issuer's incentives to call the bond, such as credit rating upgrades or major asset sales.

Understanding the call price, call frequency, and the call notification period is essential. Callable bonds are generally more suitable for short-term investors than for buy-and-hold investors. Investors should also analyse the impact on portfolio duration and yield curve positioning if the bond is called.

Puttable bonds overview

Puttable bonds are the mirror image of callable bonds. While callable bonds give the issuer the right to early redemption, puttable bonds give investors the right to demand early repayment from the issuer. Investors can 'put back' the bond to the issuer and get their principal repaid before maturity.

Put provisions help investors manage interest rate risk and reinvestment risk. If market interest rates rise after an investor purchases a bond, the put option allows them to redeem the bond early and invest in higher-yielding instruments. This provides downside protection and liquidity to investors.

In India, puttable bonds are relatively rare compared to callable bonds. Some PSUs, housing finance companies, and insurers issue puttable bonds. These bonds typically offer lower yields than comparable non-puttable bonds because issuers have to compensate for the put provision. Government bonds generally do not include put features.

Mechanics of puttable bonds

The put provision is defined at the time of bond issuance. It specifies the put dates, put price, and put notification period.

For example, a 5-year puttable bond may specify annual put dates from years 2 to 5. It may require investors to notify the issuer 15 days before the put date. On the put dates, investors can return the bonds to the issuer and receive the principal amount, which is predefined as the put price.

Conclusion

Callable and puttable bonds contain additional features compared to regular fixed-income instruments. While this increases complexity, embedded call and put options offer flexibility to issuers and investors to manage financial risks.

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Investors should assess factors like reinvestment risk, embedded pricing, volatility, liquidity, and counterparty risks when investing in callable and puttable bonds. These instruments are generally better suited for institutional investors who can model the yield and price dynamics of the embedded call or put options.