Bonds Part V: Options (Put/Call/Convertible)


No article on indian bond market can be complete without discussing the various embedded options available in them.
1. Convertible Debentures: The holder of the bonds have an option to buy a particular number of common stock (shares) of the issuing company at a pre-determined rate. If prudence is exercised then its a win-win situation for both companies. The issuing company has made their bond issue attractive and hence can offer a lower coupon rate (more operational profit). Also if the stock market is doing well, then they would be able to roll the debt by converting it to equity. Hence it is a backdoor way of IPO/FPO.
You also benefit because it will offer you capital protection because you can always redeem your bond at the face value if the stock market tanks. If you are a buy and forget kind of an investor then buying such debentures of *Blue Chip* companies will enable you earn extra returns if the price goes above the conversion price.

2. Put option: Most infrastructure bonds seem to have a put option. I.e. if the interest rate goes up, then you can encash the bonds and reinvest the proceeds at the prevailing rates. So it is a hedge against rising interest rates. Fixed deposits are popular because the investor can encash them whenever they want. Most bonds don’t offer this flexible put option, but it is a good to have feature in any bond.

3. Call Options: Unlike the Put option, the Call option gives the issuer the right to recall all the bonds from the market. This can never be good for you, because it exposes you to reinvestment risk. i.e. interest rates have fallen and you now end up with money that can only be invested in bonds that offer a fraction of the interest rates. However because of the administrative and bond issuance cost, it does not become economical for companies to exercise this option for <1% difference in rates. (so that is the only relief you get)

Being the last article in the Bond lecture, I would consider myself successful if now you realize investing in bonds (or fixed income securities) is more than just getting the highest interest rates.