Bonds with Embedded Options Definition, Valuation & Types

Stated simply, embedded options are structured into a particular financial security, thereby allowing one of the parties to execute a specific action, subject to certain terms and conditions.Factors like financial objectives, risk tolerance, investment horizons and liquidity needs vary across investors. An embedded option, in this case, provides a suite of solutions in keeping with varying investor needs.
Though inseparable from the issue, embedded options can be added to or subtracted from the core value of securities, much like the OTC or traded options.

Embedded options commonly feature in bonds, considering the size of the bond market and unique issuer and investor needs. Some of the more common types of embedded options in bonds include:

• Callable (redeemable) bonds This is a type of bond that allows its issuer to retain the right to redeem the bond at a particular time, prior to its maturity date. For instance, the issuer would want to call back bonds when prevailing interest rates drop below the rate of interest applicable on the bond.This way, the issuer would be able to save money by paying off the debt in full and subsequently issuing bonds at a lower rate of interest.
• Puttable bonds These come with an embedded put option. It implies that the bondholder, in this case, retains the right (but not the obligation) to ask the issuer for a premature repayment of the principal. The embedded put option can be exercised on one or multiple future dates.
• Convertible bond Also referred to as a convertible debt or convertible note, these can be converted into a specific number of shares (of a company’s common stock) or cash of equivalent value. This embedded option benefits the bondholder, considering the value of the bond might rise with an increase in the price of the underlying stock.

Alternatively, price of the bond can dip should there be a fall in the underlying stocks’ performance. In conclusion The key to understanding embedded options in bonds is that they are built into the security, and cannot be separated from the underlying. This is unlike derivatives that closely track performance of the underlying security.Calls and puts are the more commonly used embedded options, allowing the issuer of the bond and its holder to take opposing bets. The price of entry into either position is the primary differentiator between a vanilla bond and one with an embedded option. Also Read: What are Bonds? Meaning, Types & Important Terms

Here are the two common types of bonds with embedded options-

Callable Bonds

Callable bonds are bonds that can be called back by the issuer. This means that the issuer has the right to redeem the bond at a specific time before the maturity date.The coupon rate of callable bonds tends to be higher compared to non-callable bonds with the same maturity. As long as interest rates stay relatively low, this can potentially be beneficial for investors. However, if interest rates increase, then the issuers might redeem the bond. This might make callable bonds unattractive compared to non-callable bonds.Non-callable bonds typically pay a fixed amount of interest. Because of this, non-callable bonds tend to be less risky than callable bonds. However, they also tend to be less attractive to investors because they offer less opportunity.

Puttable Bonds

Puttable bonds are bonds that provide the holder of the bond the right to, but not the obligation to, force the issuer to redeem the bonds before the maturity date. If this option is exercised, then the holder of the bond receives the principal value of the bond.A puttable bond gives the investor the right to redeem the bond at some point in the future before maturity. However, investors can also choose not to exercise this option.
For instance, if the interest rate rises, then a puttable bond can be redeemed. This will allow the investor to receive the principal amount. The investor can use this principal amount to invest in new bonds with a higher interest rate.But if the interest rate stays the same or falls, then the investor can avoid exercising the put option. This will allow the investor to earn interest at the same rate.
This type of bond allows investors to take advantage of rising interest rates without having to commit to holding a bond until maturity.

Embedded options are features of a bond. It allows holders and issuers to take specific actions against each other in case of pre-specified conditions.
There are various embedded options in bonds, such as callable bonds, puttable bonds, etc. These options give issuers and holders the ability to take a specific action in the future in case a pre-specified condition occurs.When an investor buys an embedded option bond, they are buying a bond with an option attached to it. For instance, a person purchases a callable bond. The call option gives the issuer the right to buy back the bond at a set price before maturity.

Embedded options can have an impact on the price of a bond. These options can increase or decrease the value of a bond.For instance, a callable bond gives the issuer the right to redeem the bond before the maturity period. This can cause the investor to lose out on interest payments. However, issuers tend to offer higher coupon rates on callable bonds to get more investors . Hence, such options tend to affect the price of the bond.

An embedded option is a right that the issuer or holder of the bond can exercise if a pre-specified condition is met. Furthermore, this option can be exercised automatically based on the interest rates. Such options are embedded in an .Some of the common embedded bond options are- callable bonds, puttable bonds, etc. Let’s understand how a bond option works-A person purchases a puttable bond. However, after a few years, the interest rates rise. The put option gives the holder of the bond the right to redeem the bond before maturity. If this option is exercised, then the investor can receive his/her principal amount. This amount can be used to purchase a new bond that offers a higher interest rate .

Here are some types of bonds-

• Government Securities Bonds
• Corporate Bonds
• Convertible Bonds
• Sovereign Gold Bonds

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.