Putable bond question sharp, protection, question, interest, relative

Maddin

Hi,
R29 Relative-Value Methodologies for Global Credit Bond Portfolio Management
P.73 Structure Trades
“The sharp downward rotation of the U.S. yield curve during the second half
of 1997 contributed to poor relative performance by putable structures.
The yield investors had sacrificed for protection against higher interest
rates instead constrained total return as rates fell.”
When interest rates fall, why is the performance of a putable bond poor ?
At lower yields, the putable bond has a price-yield relationship that is similar to the
option-free bond.
Please explain the logic..
Thanks.

Carson

You are right in terms of price-yield relationship but didn’t took into account the premium you have paid. So you economically own a vanilla bond (because its far OM) for which you paid a higher price (bond price + Premium). So you end up having earned a lower price appreciation compared to the vanilla bond, which leaves you worse on a total Return basis.

invic

Thanks, IRS-Trader !!!
I can understand the logic!

pacmandefense

I think its as simple as: when rates fall, the put option on the bond becomes less valuable.
As the above poster said, putable bonds offer a lower coupon than a plain vanilla given the option available to bond holders.
So in an environment where rates fall, putable bonds under-perform compared to plain vanillas because of the lower yield and the reduced value of the option.

kingstongal

I’m confused…

Chuckrox8

Both must be equal in pv terms. My post was an upfront premium the other poster had a As you go premium. I trade OTC Bond Options where upfront premium is more common…could Be the case that in embedded options you adjust Coupon for Option Value…

RMontgomery

Manet
Take a look at V5 R43, the end of that reading. It briefly describes using a payer swaption for an issuer wanting to synthetically embed a put feature onto a bond by selling (recieving a premium) for the receiver swaption. More important, it goes through how to syntheiticallly add calls onto a bond, probably more likely to show up on the exam.

Analyze_This

put bonds have a shorter duration then equivalent no option bonds… in a declining rate environment longer duration bonds out perform short duration bonds…
another way to think of this is puttable bond prices do not decline as much as non puttbale bonds when rates rise… therefore they don’t have as much run in price when rates decline (all else equal)