What are embedded options?
Embedded options are special features which are part of a bond’s terms; these can have the effect of adjusting a bond’s maturity date, as well as changing the expected return terms on the bond. Not all bonds have embedded options; however, it is important for investors to understand how they work and how they can affect one’s investment returns and the pricing of a bond.
Common examples of embedded options
Some of the most common forms of embedded options include “calls” and “puts”. Typically, bonds with such features are structured with “issuer calls” or “bondholder puts” – the former allows an issuer to redeem a bond prior to the maturity date at a predetermined price (and date), while the latter allows the bondholder to request for the bond to be redeemed by the issuer; again, this will be at some predetermined price and date. Bonds with callable features are thus commonly termed “callable bonds” while those with an embedded put option are commonly termed “putable bonds”. It is also fairly common for bonds to be structured with a “change of control put” option; this usually serves the purposes of bondholders in the event of a takeover of the company – the company’s bondholders will thus have the right to request for the bonds to be redeemed by the issuer.
What this means for investors
For bonds with such embedded options, the simple use of a yield-to-maturity measure may not be sufficient for analysis, given that the presence of these options can significantly adjust the bond’s maturity date. Measures like “yield-to-call” become more important in the assessment of callable bonds – these can be calculated with the knowledge of the terms for each call date and price; it is commonplace for callable bonds to be referenced by a “yield-to-worst” measure, which is the lower of the “yield-to-maturity” or “yield-to-call.”
Effect on bond price
In general, embedded options can either add to or subtract from the value of a bond, depending on whether the option is a benefit to the bondholder or the issuer. For example, the presence of an embedded issuer call option is a benefit to the bond issuer, and detracts from the certainty of returns for the bondholder. As a result, a bond with an issuer call feature should, in theory, trade at a discount (and provide a higher yield) compared to a bond without such a feature, assuming all things are constant. In contrast, a bond with a bondholder put option (which can allow the bondholder to require the issuer to redeem the bond at some predetermined date) entails having an additional bondholder benefit; as such, a bond with such a feature would trade at a premium (and have a lower yield) compared to one without such a feature, again assuming all other things are held constant.
The rarely triggered Make-whole-call provision
While it is also common for corporate bonds to be structured with a “make-whole-call” provision, such calls are rarely triggered by issuers, due to the significant cost involved. In the event of a “make whole call”, the issuer has to make a one-off payment which is equivalent to the net present value of all future intended cashflows from the bond – these are usually discounted at a predetermined rate (eg. Treasury rate plus a spread). This is usually a superior outcome compared to a traditional issuer call, where all future coupon payments are discontinued given the early termination of the bond. Bondholders will essentially see their investment “made whole” as a result prior to the maturity date; the triggering of a “make-whole-call” provision is usually a positive outcome for the bondholder.
The Research Team is part of iFAST Financial Pte Ltd.