Introduction to bond redemptions

If you are already familiar with investing in bonds or fresh from our explainer about them, then you know how these investments end.  

After periodic coupon interest payments, the investor receives the face value of a bond on its maturity date. This type of bond is also called a plain vanilla bond, straight bond, or bullet bond. Over time, financial markets became more sophisticated, and plain vanilla bonds evolved into new instruments with special features.  

Enter the world of bond redemptions. Certain bonds may feature the option to end the investment earlier than the scheduled maturity date. But why would anyone want a bond to mature earlier? And who is responsible for making that decision?  

In this explainer, we will tackle what these options are and their implications for issuers and investors alike.

There are many types of bond redemptions, but they can all be condensed into two building blocks—Call Options and Put Options.  

These two options have existed throughout history as informal agreements, usually in the trading of commodities and other agricultural goods. Since then, calls and puts have been institutionalized in the global financial markets. Beyond commodities, these options are also available in bonds, stocks, and most recently, cryptocurrencies.

Related article: Bonds 101: Why price and yield move in opposite directions

A call option grants the right to buy an asset at an agreed price. It is advantageous to exercise a call option when one is interested to buy an asset but prevailing market prices are high.

On the other hand, a put option grants the right to sell an asset at an agreed price. It is advantageous to exercise a put option when one is interested to sell an asset but prevailing market prices are low.

A bond with a call option allows an issuer to buy the bond back from investors before the maturity date. This is appropriate during environments of low interest rates and high bond prices. The issuer may choose to retire the old bond and issue a brand-new bond at a lower coupon interest rate.

The investor will receive the bond’s face value much earlier, but this can also mean losing out on the last few coupon interest payments. Given the potential drawbacks to the investor, bonds with call options normally offer higher yields compared to plain vanilla bonds.

A bond with a put option allows investors to sell the bond to its issuer before the maturity date. This is appropriate during environments with high interest rates and low bond prices. Rather than wait for maturity, an investor can sell their bond above market prices and switch to another bond at potentially better levels.

Given the additional benefit to the investor, bonds with put options normally offer lower yields compared to plain vanilla bonds.

The two building blocks of bond redemptions—call options and put options—introduce greater flexibility to bond investing. These types of bonds may still be freely bought and sold in the secondary market at prevailing prices.  

Just remember that a bond with a call option gives the issuer a favorable price to buy while a bond with a put option gives the investor a favorable price to sell to the issuer. Investors should carefully consider the impact of these features before investing in certain bonds. 

Stay tuned for more explainers on special types of call options and put options!    

EARL ANDREW “EA” AGUIRRE is the Head of the Investment Counselor Department under the Financial Markets Sector of Metrobank. He has more than a decade of experience in foreign exchange, fixed income securities, and derivatives sales. He has a Master’s in Business Administration from the Ateneo Graduate School of Business. His interests include regularly traveling to Japan and learning its language and culture.