Putable bond question question

jbaldyga

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.

Darien

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)

ohai

A little illustration.

Let us assume there is a 5-year putable bond and there is another 5-year option free bond. Both have the same credit rating from the same issuer. Assuming the option free bond has a yield of 7% and the putable bond has a yield of 5% (remember that the yields/coupon on putable bonds are lower than option free yields/coupon because of the option to put). Which of these two bonds will you buy when interest rates are falling?

Also remember that the chances of default generally reduce with falling rates because of several factors (opportunity to refinance, lower rates boost economic activities, etc). This lead to the put option in a putable bond losing its value since bonds are not likely to fall in prices and hence need to be "put" back to the issuer.

With the option of buying any of the two bonds, you will prefer the one with a higher yield, which is the option free one. All rational portfolio managers will go for the option free bond and this will make it outperform the putable bond.

This is as simple as I think I can make it.

pennyless

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.

bboo

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...

Valores

I'm confused...

Colum

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.

skycfa

Thanks, IRS-Trader !!!

I can understand the logic!

Analyze_This

There is no premium paid to putable bonds. Putable bonds offer a lower coupon than option-free bonds given that they provide a long option to bondholders. As a result, these bonds are not as sensitive to interest rates and when the interest rates decline, they will offer less price appreciation.

On a side note, putable bonds are extremely rare in the market place, which makes it tricky to assess price movements given few data points historically.

Iginla2011

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.