Callable and Putable Bonds

Imagine lending money to a friend, but this time they agree on paying you back early if they come into some money sooner than expected. Alternatively, you want the option to ask your friend to repay you early if you need cash.

These flexible arrangements illustrate the ideas behind callable and putable bonds — fixed income instruments that offer issuers or investors certain rights to redeem or sell the bonds before maturity.

What Are Callable Bonds?

Callable bonds give the issuer the right to redeem the bond before its maturity date, usually when interest rates fall. This allows the issuer to refinance debt at a lower cost. However, this feature poses a risk to investors, who may have their bond redeemed early and lose out on future interest payments.

• Why Issuers Call Bonds: When market interest rates decline, issuers can call existing bonds carrying higher coupons and reissue debt at lower rates, reducing their interest expenses.
• Investor Risk: Investors face reinvestment risk since they must reinvest the returned principal at potentially lower prevailing rates.

Example: Reliance Industries may issue a callable bond at 8% coupon. If market rates fall to 6%, Reliance might call the bond early and refinance at a lower rate, cutting its interest costs but forcing investors to find new investments.

What Are Putable Bonds?

Putable bonds give the investor the right to sell the bond back to the issuer before maturity at a predetermined price. This feature offers investors protection against rising interest rates or deteriorating credit quality.

• Investor Benefit: Investors can "put" the bond back to the issuer, reducing exposure to falling bond prices.
• Issuer Perspective: Issuers usually offer a lower coupon rate on putable bonds since investors have this added security.

Example: A corporate bond with a 7% coupon might be putable after 5 years. If interest rates rise and bond prices drop, investors can sell the bond back to the issuer at the put price, mitigating losses.

Why Are Callable and Putable Bonds Important?

1. Flexibility: These bonds offer flexibility to issuers and investors to manage interest rate and liquidity risk.
2. Impact on Pricing: Callable bonds generally offer higher yields to compensate investors for call risk, while putable bonds offer lower yields because of added investor protection.
3. Risk Management: Understanding these features helps investors evaluate the risk-return trade-off accurately.

Callable and putable bonds are increasingly used in India, especially by corporations seeking flexible financing options and by investors looking for tailored risk profiles. The Reserve Bank of India has issued callable bonds, and several Indian companies have incorporated these features into their debt offerings.

Callable and putable bonds add valuable flexibility to fixed income investing but require investors to understand the embedded risks and rewards. Recognizing these features helps in making more informed investment decisions. In the next chapter, we will explore Zero-Coupon Bonds and Strips, unique bonds that do not pay periodic interest but offer different investment opportunities.