Mini Chapter Two
Types of Rate options
Let’s begin with Embedded Bond Options:
Call/Put Options embedded in Bonds
- Bonds are frequently structured with optionality in them for either the issuer or investor. Subject to relative demand supply conditions options are embedded to sweeten the deal for the investor and or cheapen the issuance for the issuer.
- Bond issuance that allows for an early redemption (issuer buying back the bond) has an embedded call option for the issuer i.e. holders of these bonds sell this call option (for an expiry shorter than the bond’s tenor) to the issuer at an enhanced yield versus a vanilla bond of the same tenor.
- While bonds that allow the investors to demand an early redemption from the issuer (i.e. put back the bond before maturity) is equivalent to the bond holders buying a put option (for an expiry shorter than the bond’s tenor) on the bond in addition to the bond itself.
- To illustrate – a corporate issuing a 10 year bond with a right to call it back at the end of 3 years is long a call option for a 3y expiry on a 7 year bond. First principles suggest that the coupon on this bond should be higher than that on a vanilla 10 year bond to compensate the investor for the option premium on the sale of call to the issuer. Additionally, the pricing would be a function of the current yield levels and the shape of the yield curve. A steeper yield curve would imply lesser premium for an issuer’s call and hence a lower kicker for the investor as option strike tends to be farther away from ‘at the money’ forward levels. Or seen another way a flatter yield curve which brings implied forwards closer to ATM increases the moneyness of the issuer’s call option enabling a large yield enhancement for the same implied yield volatility.
- Consider the issuer’s current yield curve to be: 1y: 3%, 2y: 3.5%, 3y: 4%, 5y: 4.5%, 7y: 4.75% 10y: 5%. Vanilla 10y bond can be issued at 5% but the bond with an embedded call after 3 years would be issued at a higher coupon to accommodate the call premium – say 5.25%. This premium would of course be a function of the yield volatility of this corporate’s bond curve. The issuer is effectively embedding a Call option on its 7 year bond with an expiry of 3 years. While the decision to exercise the call would depend on whether the 7y yield in 3 years’ time is below 5.25%, the pricing of it would depend on the 3y forward 7 year rate that’s at ~5.43% (i.e. OTM by 18bps).
- Impact of duration on changing option expiry, for the same bond – a key nuance of embedded bond options is how the changing embedded option expiry also changes the underlying (even if it’s the same issuer’s liability) itself as it gains/loses duration. To understand better – in our example above if the call was at the end of 7 years we would be pricing the option premium for a longer 7y expiry but on a shorter duration of the underlying (now a 3y bond). Coupon/strike on the bond would also vary (or sometimes not) based on the changing duration dynamics and shape of the yield curve. It’s possible that premium on a 7y expiry 3y tail is similar to the premium on a 3y embedded call in case the impact of 3y onward implied vols flattens out and intuitively the duration gain on the option expiry somewhat offsets the duration loss for the underlying tenor.
- Strike price for the issuer’s call – the strike price of the options we have discussed so far is determined purely by the coupon on the bond (that includes the premium in it). Issuers could also tailor a different premium arrangement for the investor to optically lower their own funding cost. Coupon on the callable bonds (while higher than plain vanilla) can be priced much lower i.e. more out of the money versus the implied forwards by pushing the option premium payment at the time (and in case) of the exercise of the call – this is typically achieved by redeeming the bond at a premium. This would result in a lower coupon premium for the full tenor of the bond. From an investor’s standpoint a redemption premium arrangement would mean a higher holding period return till the option expiry in case of an exercise (versus a vanilla bond of the same tenor as expiry). At the time of purchase the redemption premium is attractive enough to trade it off with a lower overall coupon in case of non-exercise.
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- Instead of a strike/coupon at 5.25% in our example above – the issuer could choose to pay a premium in case of early redemption of let’s say 3% (also referred to as a contingent premium product) and reduce the coupon on the embedded bond to 5.05% which would optically reduce their overall cost of funding. In case the call is exercised at 103 (roughly 50bps lower on the 7 year rate after 3 years i.e. strike at 4.55%) the investor’s holding period return would be 5.05% + ~1% = ~6.05% for 3 years.
- Bonds with embedded put options – switching the right (but not obligation) to early redemption from the issuer to the investor would flip the long option from a call to the issuer to a put to the investor. Taking a cue from our example above – a 10y bond issued with a 3y put to the bond investor would bear a coupon lower than 4% (3y vanilla rate), as a way to pay for the option to extend duration in case rates go lower. Conversely a coupon on a puttable bond at or above 4% would mean the investor is either able to buy the option for free or is being paid for it, which would create a visible arbitrage to buy these bonds and short the 3y vanilla bond. Strike for the investor’s put would be the coupon on it, and the exercise price would logically always be par (an investor would usually not reinvest their money at a premium!).
Call/Put Options embedded in Bonds
- Trivia
Offshore Investment in India’s Corporate Bonds with both put and call options
As per the Foreign Portfolio Investment rules for India’s Fixed Income Markets (before the emergence of Voluntary Retention Route, VRR in March 2019), FPIs were only allowed to buy bonds with a minimum 3yr maturity. But for those who did not wish to take credit risk on the bond for as long as 3 years, buying a 3 year bond with say an embedded 1y put/call option was another way to structure it. By way of economics the pricing of this bond would be no different from a 1y vanilla bond as the investor would exercise the put if rates went up and the issuers would exercise the call if rates went down. This was also an attractive avenue for the issuers to tap capital market funding/offshore money especially when the front end of the yield curve was relatively flat and markets were expected to be range bound. Owing to higher re-issuance costs the issuer would typically not exercise the call unless yields collapsed. Offshore investors on the other hand would look to strike a balance between not taking longer than 1y credit risk (as much as possible) and a fast rallying long carry market.
