Put and call options in bonds

Bond investors are treading extra caution as a series of downgrades has crimped their confidence. In such a scenario, they tend to seek a shield via ‘put option’, an integral part of many bond sale agreements provides an exit route. This is now billed as a safety net for investors although such perception could also fire back.

What is a put option?

This is an exit route for investors who may be looking to move out of their bond investments. At the time of bond sale, select borrowers offer both put or call or even both options, which add to investor confidence. A borrower can extinguish its debt midway without servicing the full tenor by exercising the call option.


How does it work?

Normally a bond series with 10-year maturity should have five-year put options. This means, an investor can surrender investment after five years seeking immediate redemption. A borrower is supposed to repay her/him proportionate to the five-year investment horizon.

When dose such an occasion arise?

An investor can exercise put option for multiple reasons: immediate cash requirement, a changing interest rate scenario or a rating change that might hit future repayments. Now, what is making investors nervous is the fear of future defaults amid the crisis in the non-banking finance sector. Para banks are running short of money as they face a mismatch between short liabilities and long-term assets. Moreover, a sudden fall in ratings makes it a regulatory challenge for the select group of institutional investors, which are not allowed hold debt securities beyond stipulated rating grades.

Latest case in point:

Ahmedabad-based SinTex Industries, a manufacturer of textile and yarns, last Wednesday defaulted about Rs 90 crore repayments on bonds. Investors are likely to have exercised put option for which the company did not have money to repay, sources told ET. Speculations are rife that investors are likely to exercise this option if they doubt borrower’s ability to repay amid an ongoing cash squeeze. Besides, a large domestic institutional investor too is said to have availed such an option on bonds sold by a large embattled home financier.

Can these options be risky?

Some experts say, it could be to an extent. If a company is on the verge of arranging money to repay all its pending dues and investors suddenly exercise such an (put) option, it will only draw a blank. Consequently, it may lead to lingering legal battle upsetting the applecart. The other view is that, if a company has some residual money, it may be forced to repay immediately instead of dragging it amid tough time.