Bonds with embedded options are 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 re-call an issue at a specified price on or after a set date, referred to as the call date. The position held by the investor is hence short a call, 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 an issuer to call the issue and refinance at a lower rate. 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 putable 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 long a 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.

The coupon on a putable issue would be lower to comparable option-free bonds as the risk premium for investors is lower given the investor’s discretion on the option.

Including bonds with embedded options in a portfolio of investments allows investors to lower a portfolio’s duration, provided such options get exercised. The volatility currently being experienced in global markets would be unviable for investors to do so , however, as the uncertainty surrounding market rates and yields would affect the rational decisions by option holders that would otherwise have been taken in non-volatile times.

That is, 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. Plain calls and/or puts on bonds are one of the simplest option forms amongst 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 putable bond. A convertible bond gives an 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 Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views 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. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

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