A typical novice investor when referring to ‘bonds’, perceives them as guaranteed income generating securities. Rightly so, to an extent, as fixed income securities in their plainest form return a coupon (interest) for a given nominal amount invested, and mature (are redeemed by the bond issuer) at a pre-defined maturity date. That’s a bond for you in its simplest forms.
However, nowadays, the bond market has evolved somewhat and it has become more commonplace for bond issuers to issue fixed income securities with embedded options in them. If the underlying investors are aware of the implications of the so-called added features of the bond, they need not shy away from such opportunities, merely be well informed of the underlying investment as they form part of alternative investment strategies available to investors.
An option on a bond can take the form of many provisions, though the most commonly used are call or put options.
A call option on a bond allows a bond issuer to call-redeem a bond issue at a specified price (generally, but not always, at a premium) on or after a set date, referred to as the call date. The position held by the investor is technically speaking like being a short call option, whereby the upside potential to the investor is capped by the call price, in times of decreasing interest rates.
Keep in mind, interest rates are inversely related to bond prices. A decrease in interest rates would potentially allow a bond issuer to call the issue and refinance at a lower rate, as has been the case over the past few years or so. The foregone returns on a callable bond by the investor are reflected in higher coupon rates compared to comparable option-free bond issues. The higher coupon compensates investors for the risk of a potential call option by the issuer on the bond.
Alternatively, a puttable bond allows an investor to redeem a bond to the issuer at a pre-determined price on or after a set date. The position held by the investor here is what we term as being a long put. In times of increasing interest rates, the resulting fall in bond prices is floored by the embedded put option, whereby an investor has the option to redeem the bond to the issuer. Therefore, the coupon on a puttable issue would be lower than comparable option-free bonds as the risk premium for investors is lower, given the investor’s discretion on the option.
Therefore, including bonds with embedded options in a portfolio of investments allows investors to reduce a portfolio’s duration, provided such options get exercised. Bond issuers in a call option would most likely refinance at lower interest rates, provided they have the liquidity to do so and investors holding a put option would more than likely redeem an issue at higher interest rates in search of alternative higher yielding issues.
Having said that, options on bonds can take on a vast range of provisions that can be influenced by either issuers or investors alike. Plain calls and/or puts on bonds are one of the simplest option forms among a number of more complex alternatives.
Convertible bonds, for example, are alternatives that can exist as a stand-alone option or be added to a callable or puttable bond. A convertible bond gives a bond issue an equity feature which allows investors to convert their bonds into stock at a pre-determined conversion ratio. Such bonds would trade higher than option-free bonds, predominantly due to a conversion premium that allows holders to convert and benefit from an increase in the company’s stock price.
It is important to keep in mind that regardless of an option’s simplicity or complexity, volatility such as the one currently being experienced in financial markets would impact the decisions to be taken by issuers and investors alike.
Disclaimer:
This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.