What Is a Puttable Bond?
Puttable bond gives the holder the right to sell the bond back to the issuer at a stated price on stated dates before maturity. The option belongs to the lender rather than the borrower, so it caps the price downside from rising rates and is paid for with a lower yield.
Most bonds are a fixed arrangement until maturity. A puttable bond adds an exit, and the exit belongs to the lender — which makes it one of the few structures in fixed income built in the holder’s favour.
How it works
The holder may sell the bond back to the issuer at a stated price — usually par — on specified dates before maturity.
It is a right, never an obligation. If the bond is trading above the put price, you simply do not use it, and the option costs you nothing further.
A callable bond is the mirror image. There the issuer may redeem early, which happens when rates fall and refinancing is cheaper — precisely when you would rather keep the bond.
Why it protects you
Rising rates push bond prices down. A put at par means the price cannot fall far below par for long, because you can always hand it back.
So the effective duration shortens as rates rise. The bond starts behaving like a short-dated instrument at exactly the moment long duration would hurt most, which bond duration works through.
And nothing is free. The issuer knows what they have given away and pays you a lower coupon for it — the protection is bought, not granted.
A worked example
A ten-year bond, duration 8, with a put at par in year three. Rates rise one percentage point in year two.
A plain ten-year bond falls about 8%. The puttable one falls far less, because a holder who can redeem at 100 in twelve months will not sell at 92 today.
Its price behaves like a one-year instrument, because that is effectively what it has become. The stated maturity is ten years and the economic maturity is now three.
The cost appears in the coupon. If the plain bond pays 5%, the puttable one might pay 4.4% — and over the years where rates do not rise, that 0.6% is what the unused protection cost.
Who issues one and why
Issuers accept the put to borrow at all. A lower-rated borrower may be unable to sell ten-year debt at any sensible yield, and adding a put shortens the risk lenders are taking.
Or to borrow more cheaply. The coupon saving can exceed what the option is worth to the issuer if they expect rates to stay put, which is a judgement they may be wrong about.
And it creates a funding risk for them. A put exercised by everyone at once is a sudden demand for cash, arriving when rates are high and refinancing is expensive.
Which is the structure’s hidden weakness from the holder’s side. The put is only as good as the issuer’s ability to pay it, and the circumstances that make you want to exercise — rising rates, a deteriorating borrower — are exactly the circumstances where their ability is least certain.
The original data
This site’s thirty-year fee measurement: 5 basis points costs 1.5% of the final balance, 20 costs 5.8%, 75 costs 20.2%, 150 costs 36.5%.
Put that beside a 0.6% coupon give-up and the comparison is stark. The embedded option in this structure costs roughly 60 basis points a year — more than three times a 20-basis-point fund fee — and it is never described as a cost anywhere in the documentation.
And the trading cost applies too: a round trip costs 0.0098 on this site’s series, about 2% of the median bar range of 0.493. Puttable issues are usually smaller and less traded than plain ones, so the real spread is wider than that.
How to value what you are holding
Read the put schedule, not the maturity. The dates and prices are in the prospectus, and they are what determine how the bond behaves.
Compare the yield to worst, not the yield to maturity. For a puttable bond the relevant figure is the yield assuming the least favourable outcome for you, which is usually holding to the stated maturity.
And check whether the put is at par or at a premium. Some are structured to redeem above par, which changes the arithmetic considerably.
The general rule is that an embedded option always belongs to somebody. Establish which side holds it before anything else, because a bond with an issuer option and a bond with a holder option are different instruments wearing similar descriptions, and the yield difference between them is the market pricing exactly that.
When it fails
The characteristic failure is a put that cannot be honoured. The holder buys the structure for its floor, rates rise, the issuer’s credit deteriorates, and the put date arrives — at which point exercising requires the issuer to find cash they may not have. A put against a distressed borrower is an unsecured claim like any other, and the protection that made the bond attractive evaporates in precisely the scenario it was bought for. The option was real; the counterparty behind it was the weak part.
A second failure is missing the exercise window. Puts are exercisable on specific dates with notice periods, and an unexercised option expires worthless.
A third is paying for protection you do not need. A holder who intends to hold to maturity regardless of price is buying an option they will never use.
A fourth is comparing its yield to a plain bond’s and calling it expensive. The yields differ because the instruments differ.
And a fifth is assuming the stated maturity is the real one. For a puttable bond it usually is not, and every duration and cash-flow calculation built on it is wrong.
Related
Callable bond covers the mirror structure where the issuer holds the option. Bond duration covers the exposure a put truncates. And corporate bond covers the credit standing the put ultimately depends on.
Every embedded option in a bond is owned by somebody, and the first question on any bond is which side owns it. A callable bond’s option belongs to the borrower and works against you; a puttable bond’s belongs to you. Almost everything else follows from that one fact.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.