What It Is:
How It Works/Example:
The bond indenture will stipulate when and how the bond can be sold, and there are often multiple sell dates throughout the life of a putable bond. Many corporate and municipal securities have one- to five-year put provisions.
To understand how the put works, let's consider an XYZ bond issued in 2000 and maturing in 2020. The indenture stipulates that the holder may put (sell) the bond after four years. The put provision in the indenture also sets forth the put price, which is what the issuer must pay to redeem the bond. Usually the put price is 100% of face value. In our example, the indenture might say, "The XYZ bond due June 1, 2020 is putable on June 1, 2004 at 100% of par." (The indenture typically provides a table of put dates and prices as well if applicable.)
Recall that when interest rates rise, prices of bonds issued at older, lower rates fall and vice versa. Thus, if interest rates are at 3% on June 1, 2004, but the XYZ bond is only returning 2%, the holder will probably put the bond, get his money back, and reinvest it in something with a higher return. If, however, market returns for similar bonds have fallen to 1%, the XYZ bond is worth more, and the investor will probably be content to hang on to his bond and get above-average market returns.
Why It Matters:
The advantage of putable bonds is that if interest rates rise after the investment date, therefore reducing the bond's value, the investor can recover some or all of that loss by forcing the issuer to redeem the bond at par value.
Put provisions considerably alter bond analysis because they change two dimensions of risk to bondholders. First, they lower reinvestment risk: When interest rates rise, the bond issuer is more likely to exercise the put provision in order to get out of what has become a low-return investment and reinvest that money at the prevailing higher rate. This also leaves the issuer with the probability that it will suddenly need to come up with cash to redeem the bonds, and it must do so in what is probably a high-rate environment. There is clearly the chance that the issuer can't raise the cash and thus can't redeem the bonds, which is why many putable bonds are guaranteed (that is, a third party, usually a bank, has agreed to pay the bondholders if the issuer can't).
Second, put provisions limit a bond's potential price depreciation, because when interest rates rise, the price of a putable bond will not go any lower than its put price.
Intuitively, a putable bond is just a traditional bond with a put option attached. Thus, the price of a putable bond can also be intuitively split into the price of the nonputable bond and the price of the put option. This is why options pricing models can be used to price putable bonds and calculate their option-adjusted yields, durations, and convexities.
Because put provisions are more favorable to investors, bonds with put provisions tend to be worth more than similar nonputable bonds. If issuers of these bonds feel they receive enough compensation for the risks associated with put provisions, they can be an excellent way to raise capital.