The debt market, also known as the credit market is an integral part of the financial system in the country. It helps infuse money into the economy through the issue of debt. One of the major components of the Indian debt market is the bond market. To understand call and put options in bonds, it is important to first comprehend what bonds signify as a security.

What is a bond ?

A bond is a fixed-income debt instrument that represents an agreement between the issuer and the investor; where the investor loans out the principal money to the issuer who stays indebted to the investor. The issuer is obligated to repay the principal amount to the investor after a specified period on the maturity date.

During this period, the issuer also compensates the bond-holder with interest based on the coupon rate, which will be paid out at regular intervals. Bonds can be publicly traded in the secondary market through OTC (over-the-counter) platforms. Some bonds may come with an additional embedded feature called ‘call or put option in bonds.’

Interest Rates vs Bond Prices

Interest rates have an inverse relationship with Bond Prices. When interest rates are on the rise, the bond’s value starts to deplete as its coupon rate starts to seem less attractive. On the other hand, when interest rates are declining, bond prices surge upwards as the coupon rate seems more favourable than the ongoing interest rates in the market.

Call Option in Bonds

A call option in bonds gives the issuer of the bond the option to call back the bond before its maturity by paying back the principal amount. Such bonds are known as Callable Bonds.

This option can be exercised by the issuer when interest rates decline as capital requirement can now be met at a lower cost. Another reason to call back the bond would be when the company’s credit rating improves as the company can borrow money at a lower coupon rate.

For example, A company ABC Ltd. borrows Rs. 1 crore by issuing bonds that mature in 10 years at a coupon rate of 8%. If the interest rates decline to 7% in the 7th year, the company can call back the bonds and re-issue fresh bonds at a lower rate.

Put Option in Bonds

A put option in bonds gives the holder of the bond the right to enforce repayment of the principal amount before the maturity period. Such Bonds are called Puttable Bonds.

This option can be exercised by the bond-holders when interest rates are rising and they fear a decline in the value of the bond and want their principal back before that. The issuer embeds a put option in the bonds to entice the prospective investors to purchase the bond or to give the benefit to the issuer of a lower coupon rate.

For example, A company ABC Ltd. borrows Rs. 1 crore by issuing bonds that mature in 10 years at a coupon rate of 8%. If the interest rates rises to 9% in the 7th year, the investor can exercise the put option embedded in the bond and be entitled to receive the principal repayment before the bond value declines. Hence the investor ends up being protected against unfavourable changes in interest rates.

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DISCLAIMER

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.



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