Bonds, their embedded option and the current scenario

The term ‘embedded option’ within bonds might have no meaning for most retail investors, however its complexity should be appreciated and understood. Most investors believe that once they purchase a bond, interest will be paid annually or semi-annually, while capital will be re-paid at par on a pre-specified maturity date, assuming no default. In actual fact this perception is solely applicable for the better known ‘straight bonds’. Straight bonds are the typical local corporate issues, but foreign issuers opt for different structures including those with embedded options.

Nowadays most issuers insert some sort of complexity when issuing bonds, to primarily safe guard their positions in times of volatile interest rate movements. When a company issues a bond with an embedded option within its structure, the maturity of the bond does not remain the main focus for a bondholder. That said the complexity of the bond would be specified in the offering supplement.

A bond with an embedded option can be callable or putable. However, the former is by far the most prevalent type of embedded option. A callable bond is a bond that includes a call option and such option favors the issuer rather than the investor (however the investor is compensated through a higher coupon). In fact, the issuer has the right to redeem the bond prior maturity at pre-specified dates, usually at premium levels from par as a sweetener for investors. In addition, most callable bonds are also issued with a so-called ‘non-call period’, in which the issuer can’t redeem the bond prior a specified number of years. Callable bonds can be of ‘European style’, in which the option can be exercised on a single date after the non-call period, ‘American style’ which are continuously callable after the non-call period or ‘Bermudan style’ in which the option can be exercised on predetermined schedule of dates after the non-call period.

The callable option is primarily an interest rate play and in fact early redemption occurs when the issuer has the opportunity to pay-off a high-coupon bond and re-issue another with a lower coupon. Case in point is the current scenario in which most high yield issuers are opting to exercise their call option and re-finance their debt at much lower rates.

This situation is surely beneficial for the issuer both from a lower interest expense perspective and also from a longer maturity ladder point of view. Two factual examples which come to mind are the recent issues by Crown European Holdings, one of the largest packaging companies in Europe which re-financed in Europe at 2.625 per cent and Country Garden, the Chinese real estate giant, which re-financed with an USD650m dollar issue at lows of 4.75 per cent. For the avoidance of doubt, both companies are high yield issuers.

On the contrary, a putable bond is an advantage for an investor. In such type of embedded option, the investor can sell the bond at predetermined levels on specific dates usually at par. This option safeguards the investor from increasing interest rates. In actual fact, putable bonds are nowadays merely issued and the put options are solely being included in offering supplements to safeguard investors from a possible change of control of the issuer.

The current interest rate scenario, primarily in Europe, is prompting companies to exercise their call option. This is surely at the expense of investors which are being faced with re-investment risk. The current environment is remarkably challenging for retail investors which are more conversant with direct bond investing.

As I have opined in my previous articles, investors are surely not getting paid nowadays for the risk being taken by investing in direct bonds. My advice in this scenario consider investing in high yield bond funds which are actively managed. Such investment vehicles tend to seek high returns with lower risk, mainly through diversification.