Embedded Options in Fixed income Securities

Options and derivatives are generally associated with equity securities. It is for this reason that most investors are not aware that they can also buy bonds with embedded options from the market. Options significantly change the risk profile of the bonds being issued. It is for this reason that bonds that have embedded options need to be valued differently as compared to other bonds. In this article, we will have a closer look at what embedded options are and how they impact the valuation of the bond.

How Do Embedded Options Work?

Fixed-income security is essentially a contract between two parties. As a part of this contract, the investors hand over their money to the company for a specified time. Under normal circumstances, neither party has the right to walk away from the contract till the predetermined time period has elapsed.

For instance, if the bond is issued for 10 years, then neither the investor nor the company can unilaterally decide to end the contract before 10 years. Embedded options in fixed income securities provide both parties with the option to end the contract prematurely if it is favorable for them to do so.

There are two types of embedded options which are commonly used in the fixed income securities market. These two types are called callable bonds and puttable bonds. The details are explained below:

1. Callable Bonds: A callable bond is advantageous to the company which is issuing the bond. However, it is not advantageous for the investors. This is because callable bonds give the company the right to call back their bonds from investors before the contract duration has ended. This means that the company can return the principal outstanding to the investors and can extinguish the bonds.

   The indentures related to callable bonds clearly explain the price at which the bonds can be called. Sometimes the price is mentioned in reference to a base price. At other times, the absolute price is mentioned in the agreement.

   This feature allows the company to avoid paying excess interest. For instance, a company may have borrowed money at 12% per annum for a ten-year period. However, at the end of the 5th year, the interest rate in the open market may have fallen to 8%. Hence, if the company were to borrow money in the current market, they would have to pay only 8%. Therefore the 4 percentage points which they are paying are because they locked the price earlier.

   In such cases, if the bond is a callable bond, the company can exercise its right to pay back the principal to the bondholders and extinguish the 12% bond while raising the same amount using an 8% bond. It is easy to see why this jeopardizes the interest of the investor. The investor who had locked in a rate of 12% would now be sitting on a pile of cash which they would have to reinvest at 8%.

   Since the call option provides power to the company, they have to pay the bondholders in order to have this option. The valuation of bonds with embedded options is done differently as compared to regular bonds. The price of these bonds is derived into two parts. One part is derived based on the discounted cash flow valuation whereas the other part is decided based on the value of the call option.

2. Puttable Bonds: Puttable bonds are the exact opposite of callable bonds. Instead of giving power to the company, puttable bonds give the same power to individual investors. In case fixed income security has a put feature, it gives the users the power to unilaterally cancel the contract if it is in their interest to do so. Once again, the bond indenture provides guidelines about the price to which the investor is entitled to when they sell the bond.

   The situation in which this option is exercised will be the opposite of what has been mentioned above. In these situations, the investor would have lent out money when the prevailing interest rate was 8%. However, over time, the market rate may have increased to 12%. Hence, the investor would now be earning a lower rate of return.

   If the bond is embedded with a put option, the investor can exercise it and the company will have to release funds to the investor. They can then redeploy these funds at a higher interest rate in order to earn more.

   In this situation, the contract is asymmetrical in the favor of the investor. Hence, the investor will have to pay a premium to the company. This is taken into account while valuing such a bond. The valuation is a combination of the value of the bonds and the value of the option.

Even though embedded bonds are very useful to both parties, they tend to make the contract asymmetrical in the favor of one party. Hence, investors need to be very cautious while buying such bonds. They need to ensure that they understand all the terms and conditions mentioned and read the fine print carefully before they invest their hard-earned money in such bonds.