Puttable Bonds in India: Meaning, Types and How They Work

Bonds are among the most popular fixed-income securities, allowing investors to earn regular interest while aiming to preserve capital. However, interest rate changes and market conditions can affect the attractiveness of long-term bond investments.

Puttable bonds can be a great choice for investors who want more control over their fixed-income instruments. A puttable bond, or put option bond, lets investors exit before maturity at a predetermined price, subject to the terms of the issue.

This article explains what puttable bonds are, how they work, their types, differences, advantages, limitations, and who should consider investing in them.

What are Puttable Bonds?

Puttable bonds are fixed-income debt securities that give investors the right, but not the obligation, to sell their bonds back to the issuer before maturity at a predetermined price. This type of bond is also known as a put option bond.

Unlike traditional bonds, where investors receive the principal amount at maturity, puttable bonds offer an early exit opportunity on specified dates. This makes them attractive to investors who want flexibility and protection against unfavourable changes in interest rates.

Example:

An investor purchases a puttable bond worth ₹1,00,000 with an annual coupon rate of 8% and a 10-year maturity. The bond includes a put option that can be exercised after five years at its face value.

The investor receives annual interest payments of ₹8000 annually. After five years, if the market interest rates increase to 10%, the existing 8% bond may become less attractive.

Therefore, after five years, the investor may exercise the put option and receive ₹1,00,000 back from the issuer. The investor can reinvest the capital in other fixed-income securities offering higher returns.

Note: Exercising a put option is not compulsory; it's a choice.

Also Read: What are Covered Bonds?

How Do Puttable Bonds Work?

Puttable bonds work through an embedded option that gives bondholders the right to sell their securities back to the issuer on specified dates. The bond issuer must honour this obligation under the bond agreement.

The process of investing in puttable bonds works as follows:

• Bond Issuance:

The issuer offers bonds with a predetermined face value, coupon rate, maturity date, and terms governing the put option.

• Investment:

Investors purchase these bonds and receive periodic interest payments according to the coupon schedule.

• Put Option Date:

The bond reaches a predetermined date when investors can exercise their right to sell it back to the issuer.

• Investor Decision:

Investors evaluate prevailing interest rates, market prices, and alternative investment opportunities before exercising the put option.

• Repayment:

If investors exercise the option, the issuer repurchases the bonds at the predetermined price, subject to the bond agreement.

• Continued Investment:

If investors do not exercise the put option, they continue holding the bonds until another specified put date or maturity.

When Might an Investor Use the Put Option?

There are two possible scenarios in which an investor might choose to exercise the put option:

• When market interest rates rise, the coupon rates on existing bonds may become less attractive. Therefore, the investor may use the put option to redeem their bond at an agreed price and reinvest the money in new bonds offering higher rates.

• When an issuer's credit quality weakens, credit rating agencies may downgrade the bond, reducing its market value and increasing the risk of default. In such cases, investors may exercise the put option and sell their bonds back to the issuer.

Types of Puttable Bonds

Puttable bonds are classified into two types: traditional and extendable puttable bonds.

Traditional Puttable Bonds

Traditional puttable bonds allow investors to sell their bonds back to the issuer at predetermined dates before maturity. The repurchase price is specified in the bond agreement and may be equal to the face value.

Investors can exercise this option when market conditions become unfavourable or better investment opportunities become available.

Extendable Puttable Bonds

Extendable puttable bonds combine an investor’s right to sell the bond back to the issuer on specified dates with a provision to extend its maturity.

The extension may involve revised interest rates or maturity terms specified in the bond agreement. These bonds offer flexibility but require investors to understand the conditions governing extension and redemption.

How is a Puttable Bond Valued?

A puttable bond is valued by adding the value of a straight bond and the value of the put option.

• Value of Puttable Bond = Value of Straight Bond + Value of Put Option

Here,

Value of the straight bond: The value of a straight bond is calculated by discounting the future coupon payments and the final principal repayment to their present values using prevailing market interest rates.

Value of the Put Option: This represents the right, but not the obligation, of the bondholder to sell the bond back to the issuer at a predetermined price before maturity.

Note: A puttable bond will always trade at a higher value or equal to a comparable straight bond.

Factors Affecting the Puttable Bond Valuation

Here are key factors that affect a puttable bond's valuation.

• Face Value:

The principal amount determines the repayment value when the investor exercises the put option or the bond reaches maturity.

• Coupon Rate:

Higher coupon payments generally increase the bond's value, assuming other factors remain unchanged.

• Market Interest Rates:

Rising market interest rates can reduce the value of existing bonds, making their embedded put options more valuable.

• Time to Maturity:

The remaining maturity period influences the present value of future interest payments and the principal repayment.

• Put Option Price:

A higher predetermined redemption price generally increases the value of the embedded put option.

• Issuer Credit Risk:

The issuer's financial strength influences its ability to make interest payments and honour the repurchase obligation.

Difference Between Puttable and Callable Bonds

Here are the main differences between puttable and callable bonds:

Advantages of Investing in Puttable Bonds

Puttable bonds offer several advantages to investors looking for flexibility and predictable fixed income.

• Early Exit Flexibility:

Investors can redeem their holdings before maturity on specified dates without depending on secondary market liquidity.

• Interest Rate Protection:

The put option allows investors to exit existing bonds when rising interest rates make alternative investments more attractive.

• Greater Investment Control:

Investors can decide whether to continue holding bonds or exercise their redemption rights based on market conditions.

• Predictable Interest Income:

Investors receive predetermined coupon payments throughout the holding period, subject to the issuer's payment obligations.

Limitations of Puttable Bonds

Despite several advantages, there are some disadvantages of puttable bonds:

• Lower Coupon Rates:

Puttable bonds may offer lower coupon rates than comparable straight bonds because investors receive the additional benefit of an embedded put option.

• Issuer Credit Risk:

Investors remain exposed to the possibility that the issuer may default on interest payments or fail to honour its redemption obligations.

• Limited Availability:

Puttable bonds may not be widely available across all issuers and maturity categories in the Indian bond market.

• Restricted Exercise Dates:

Investors can generally exercise the put option only on predetermined dates rather than whenever they want to exit.

Who Should Invest in Puttable Bonds?

Puttable bonds may suit conservative investors who want predictable interest income and the option to exit before maturity.

These bonds may also suit investors who expect interest rates to rise and want the flexibility to reinvest their capital in higher-yielding fixed-income instruments.

Investors with medium-term financial goals may consider these bonds when their investment horizon does align with the bond's maturity period. Similarly, individuals who prioritise liquidity and investment flexibility may find the put option useful.

However, investors should evaluate the issuer's creditworthiness, coupon rate, redemption price, put option dates, and associated risks before investing.

FAQs

What is a put option bond?

A put option bond is another term for puttable bonds. It gives you the right to sell the bond back to the issuer before maturity at a predetermined price and on specified dates.

A put option bond is useful when market interest rates rise, and you no longer want to hold the existing bonds.

What is the difference between puttable and callable bonds?

In a puttable bond, the investor can sell back the bond to the issuer before maturity. Whereas, in a callable bond, the issuer repays the bond before maturity.

When should an investor exercise the put option in a bond?

An investor may exercise the put option on a bond when market interest rates rise and they want to reinvest at higher rates, or when the issuer's credit quality downgrades.

Are puttable bonds safe?

Puttable bonds allow investors the flexibility to sell the bond back before maturity. However, they still carry credit risk, and investors may not recover the full amount if the issuer defaults.

Are puttable bonds available in India?

Yes, puttable bonds are available in India, but they are less common than regular corporate or government bonds.