Retractable bonds are also called putable bonds or simply put bonds. These bonds come with an additional feature of put option attached with the straight bonds. The put option allows the bondholder to retract principal investment made in the bond.
Bond issuers also hold the right to retract the bond in some cases. However, usually, the right is exercised by the bondholders.
Deeper Definition
A retractable or putable bond holds a put option that allows the bondholder to retract the principal investment in the bond.
Bondholders keep the right to redeem their initial investment. Once exercised, the issuer would repay the principal amount to the investor. The retraction is made at the face value of the bond. The issuers do not need to make coupon payments if the bondholders exercise the put or retraction option.
How Does Retractable Bond Work?
The put option embedded with a straight bond secures the investors from the interest rate risks. Investors hold the right to exercise the put option and force the issuer to redeem the investment in the bond.
An issuer trying to raise capital from the market can embed the put option through a retractable bond. Since a put option offers additional incentive to the investors, the issuers offer the putable bonds at lower interest rates than straight bonds. Conversely, due to the flexible put option, the price of the retractable bonds tends to be higher in the market than plain bonds.
Often, investors set a base period with putable bonds before the bondholders could exercise the put option. It secures the issuer against the financing and interest rate risks for a limited period. The bondholders have the right to put option. However, it does not come as an obligation. Bondholders can assess the interest rates in the market before making the final call on the retractable bond.
Investors can set certain occurrences or conditions for exercising the put option. Put bonds can embed a put option that can be exercised once or on different occasions before the maturity date of the bond.
Special Considerations with Retractable Bonds
A retractable bond’s price is set higher than a straight bond irrespective of the market interest rates. Since the bondholders have the right to a put option, it secures them against the interest rate risks. Issuers offer lower than market interest rates on retractable bonds for bearing the risks.
Issuers secure their interests by attaching specific conditions with put bonds. These terms and conditions may specify a put period or specific date before which the put option cannot be exercised. Issuers can also specify certain conditions before the bondholder could exercise the put option.
A retractable bond offers a lower yield to investors. However, the market price of the retractable bond is always higher. This price can be determined by combining the future cash flows from coupon payments and put options at different intervals. A put option with different interest rates yields different pricing. Hence, the total market value of the retractable bond can be calculated after assessing the market interest rate plus the put option feature impact.
Example
Suppose a company issues a retractable bond worth $1 million with a maturity period of 10 years and an interest rate of 1.25%. The issuer attaches a put option after five years locked period.
After five years, the holder would have the right to exercise the put option and redeem the principal investment. The principal repayment is made at the face value of the bond. The investors would exercise the put option if interest rates increase and keep the bonds if the interest rates fall. However, the put option does not come as a legal obligation for the bondholder.
Advantages of Retractable Bonds
Retractable or put bonds offer different advantages to issuers and investors.
- Investors can lower their interest rate risks.
- Investors can reduce their reinvestment risks.
- Issuers can secure financing with lower interest rates.
- These bonds offer flexible terms for both parties.
- Investors can use these bonds for consistent coupon income and trading instruments.
Disadvantages of Retractable Bonds
Retractable bonds also offer some limitations to both parties in the arrangement.
- Investors receive lower coupon payments with retractable bonds.
- Often, investors cannot exercise the put option before certain dates or conditions set by the issuer.
- Issuers can face increased costs of borrowing if the bondholder exercises the put option.
Conclusion
Retractable bonds offer a put option to the bondholders. These bonds offer a lower yield but a higher market value for investors. Issuers can secure their interests by adding certain conditions and specific dates before the put option could be exercised. Retractable bonds offer a flexible option for investors and lower the reinvestment and interest rate risks.
