Governments and corporations issue bonds to secure funds to meet their capital requirements. The bond issuer promises to pay interest to the investor in exchange for the capital borrowed. Callable and puttable are types of bonds with unique features.
A callable bond gives the issuer the option to redeem the bond prior to its maturity date. On the other hand, a putable bond gives the bondholder the option to sell the bond prior to its maturity date.
Let’s understand how callable and puttable bonds work and why you should invest in them.
What are Callable Bonds?
Callable bonds give the bond issuer the right, but not the obligation, to redeem the bond before its maturity date. Callable bonds are also called redeemable bonds.
Companies aim to reduce their interest obligation by having the flexibility to settle their debts before the bond maturity. For instance, if the interest rates are in a declining trend, the bond issuer can call the existing bonds and issue new bonds at a lower rate. By opting to call the bond early, companies can seize the opportunity to re-borrow at more favourable rates. Also, if the issuer has surplus funds, they can reduce their interest cost by redeeming the bonds before their maturity.
If the issuer does not stand to benefit from such early redemption, they may choose not to exercise this right.
Types of Redemption Options
The following are different redemption scenarios under which the bond issuer can call/ redeem the bonds before their maturity:
- Optional Redemption: Under this redemption, the issuer can redeem bonds as per their terms after a certain period. For example, municipal bonds can be redeemed after a certain period – usually after ten years.
- Sinking Fund Redemption: Under this option, the issuer has the flexibility to redeem a certain amount of the bond at fixed intervals. With a set schedule, the issuer repays a portion of the borrowed capital to the bondholders on the specified dates.
- Extraordinary Redemption: The issuer can redeem these bonds before their maturity if a particular event occurs. For instance, If callable bonds were issued to finance a construction project that gets unexpectedly halted, the issuer can redeem the bonds.
How Do Callable Bonds Work?
If the issuer decides to redeem the bonds before their maturity, they redeem it at a price higher than the face value of the bond. The high price that the bond issuer pays is called the call premium.
The call premium is paid as a reward to the investor to compensate for the loss of interest – since the bond is redeemed before maturity. The call premium is usually lower when the maturity date is close by and vice-versa.
No call premium is paid if the issuer does not redeem (call) the bond before maturity and is redeemed at its face value.
Some callable bonds have a call protection clause. The call protection clause specifies a timeframe during which the issuer is prohibited from redeeming the bond. Usually, this clause applies during the initial period of the bond. However, it totally depends on the issuer.
Example
Let’s understand how callable bonds work with the help of an example.
You invest in callable bonds issued by Company ABC for Rs 1,00,000 on April 1, 2023. The duration of the bond is seven years, and the company offers 7% interest on the capital borrowed. The bonds are issued with a call protection clause. The company cannot call for the bonds for the first three years, i.e., April 1, 2023, to March 31, 2026. From April 1, 2026, onwards, the ABC can redeem/ call the bonds anytime.
Let’s say on October 1 2026, ABC decides to call for the bonds. The company offers to pay Rs 1,00,500 for each bond. A call premium of Rs 500 per bond. So, you will now receive a premium of Rs 500 per bond.
Why Should You Invest in Callable Bonds?
Callable bonds offer several advantages for investors. Let’s look at some reasons why you should invest in callable bonds in India:
- High Interest: Usually, callable bonds offer higher interest rates than regular bonds. This is to compensate for the call option that the issuer can exercise anytime during the bond tenure.
- Call Premium: If, during the bond tenure, the issuer redeems the bond, they pay a higher value for redemption. In other words, the issuer will pay a value higher than the bond’s face value. This is to compensate for the loss of interest income.
What are Puttable Bonds?
Puttable bonds are the opposite of callable bonds. They give the bondholder the right to sell the bonds before the maturity date. However, the bondholder is not obliged to sell the bonds before the maturity date. In other words, the bondholder can force the issuer to buy back the bonds before the maturity date but can hold it until maturity if they want to.
Bondholders usually exercise their embedded put option if the interest rates rise during the tenure of the bond. Since interest rates and bond prices are inversely related to each other, the bond price falls when interest rates rise. In such a case, bondholders do not have any incentive to hold the bond until maturity and exercise the put option as the market interest rates are higher than the bond interest rate.
In contrast, if the market interest rates are lower than the bond’s interest rate, the bondholder will not exercise the put option and will hold the bond until maturity.
Types of Puttable Bonds
Following are the different types of puttable bonds.
- Multi Maturity Bonds: This type of puttable bond has multiple maturity dates. The bondholder may or may not exercise the embedded option based on the market condition.
- Option Tender Bonds: It is a floating rate bond backed by a municipal or a tax-free bond. Here, the bondholder has the right to request earlier repayment from the bond issuer.
- Variable Rate Demand Obligation (VRDO): It is a long-term bond where the principal amount is payable on demand, and the interest is payable at existing market rates.
How Do Puttable Bonds Work?
When bondholders decide to redeem the bond before maturity, they will receive the principal amount back. However, the bond has a low-interest rate compared to other bonds to compensate the bond issuer for the additional risk they might face if the bondholder exercises the option. In case bondholders don’t exercise the option, the issuer will repay the principal back on maturity.
Puttable bonds are a win-win for both the bondholder and issuer because they provide protection against interest rate increases to the bondholder and ensure a low cost of debt for the issuer.
Example
Let’s understand puttable bonds with the help of an example. You invest Rs 1,00,000 in puttable bonds of Company B at an interest of 7% per annum for a tenure of 7 years. After three years, the interest rates in the market rise above 7%.
Since you can earn better by investing the same amount in a new bond, you decide to exercise your right and ask the company to repay the principal. Now, Company B has no other option but to repay your money. The company will give you your entire principal amount and will not pay any interest from the next month or quarter. You can now invest this money in another bond offering a higher interest rate.
If the interest rate in the market remains the same or falls below 7%, then you need not exercise the embedded option as you are earning higher interest with your bonds. Then, the issuer will continue to pay the interest until you exercise your right or until maturity.
Why should one invest in puttable bonds?
Investing in puttable bonds has several advantages. Let’s look at some reasons why you should invest in puttable bonds in India:
- Low risk: Fixed income instruments have interest rate risk and default (credit) risk. Bonds with a put option get immunity against both these risks. This is because put options can be exercised if the default risk increases, or interest rate goes up. .
- Flexible investment: Investing in puttable bonds gives you the flexibility to either hold the bond until maturity or redeem it when you want.
- Diversification: Investing in puttable bonds can help you diversify your portfolio and reduce the risk of other aggressive investments on your portfolio returns.
Difference between Callable and Puttable Bonds
| Basis of Difference | Callable Bonds | Puttable Bonds |
| Meaning | Callable bonds give the issuer the right to repurchase the bonds before maturity. | Puttable bonds give the bondholder the right to redeem the bonds before maturity. |
| Right of early redemption | With the issuer | With the bondholder |
| Redemption price | Can be Higher than face value | At face value |
| Use of embedded option | When interest rates fall | When interest rates rise |
| Interest rate of the bond | Higher when compared to ordinary bonds | Lower when compared to ordinary bonds |
| Obligation of early redemption | The bondholder is obligated to sell the bonds | The issuer is obligated to repay the investment |
| Benefit to the other party | Bondholder receives call premium | The issuer pays a lower interest rate |
Conclusion
Callable and puttable bonds are embedded option bonds which are used specifically by issuers and bondholders to protect themselves from interest rate risk, and downgrade of credit ratings. Callable bonds give issuers the right to buy back the bonds at a higher premium if the interest rates in the market fall. In contrast, puttable bonds give the right to sell the bonds to the issuer if the interest rates in the market rise. Although callable bonds pay a higher interest, puttable bonds are more attractive to investors as they protect against rising interest rates.
Frequently Asked Questions (FAQs)
Is interest income from callable and puttable bonds taxable?
Yes, the interest income from bond investments is taxable. The interest is added to your total taxable income and is taxed as per the applicable slab rates.
Do all companies issue callable or puttable bonds?
No. Not all companies issue callable or puttable bonds. The type of issue depends on the company’s business strategy and fund requirements.
Can a bond be both callable and puttable?
Yes, it is possible to structure a bond with both the call and put option.A bond with an embedded option given to the investor can have both call and put option when the issuer creates such a bond structure.
What are the disadvantages of callable bonds?
The main disadvantage is reinvestment risk. If interest rates decline, issuers often recall bonds. While you may receive a call premium, you face the challenge of reinvesting at lower rates if you choose to invest in other bonds.
Additionally, if the bond is called, you lose potential interest income that would have accrued if the bond had matured. The call premium may not fully offset the loss of interest income.
What are the disadvantages of puttable bonds?
Puttable bonds offer lower yields than any other bonds because of the put option. Also, at times, issuers may offer only a single window exercise, the put option.
