Investors are challenged with the task of understanding many asset classes, the volatile world of international investing and currency swings, creative accounting and reporting, bankruptcies and defaults of once dominant companies, not to mention the complex world of derivatives. There is one concept in investing that sounds complicated but once broken down is not that complex: a variety of embedded options are commonly used and many investors own them, whether they realize it or not.

Once the basic concepts and some simple rules are mastered, any investor has a roadmap to understanding even the most complex embedded options. In the broadest terms, embedded options are components built into the structure of a financial security that provide the option of one of the parties to exercise some action under certain circumstances.

Each investor has a unique set of income needs, risk tolerances, tax rates, liquidity needs and time horizons; embedded options provide a variety of solutions to fit all participants. Embedded options are more common in bonds and preferred stocks but can also be found in stocks. There are as many varieties of embedded options as there are needs for issuers and investors to alter the structures of their agreements, from calls and puts to cumulative payouts and voting rights, and one of the most common, conversions.

While embedded options are inseparable from their issue, their value can be added or subtracted from the core securities price just like traded or OTC options. Traditional tools like the Black-Scholes option pricing model, the Black-Derman-Toy model and other bespoke tree pricing models can be used to value the options, but for the average investor can estimate the value on a callable bond as the spread between the YTC and YTM.

Embedded options are found more often in bonds due to the sheer size of the bond market and the infinite unique needs of issuers and investors. Some of the most common forms used in bonds are as follow:

Callable Bonds
A tool used by issuers, especially at times of high prevailing interest rates, where such an agreement allows the issuer to buy back or redeem the issued bonds at some time in the future. In this case, the bond holder has essentially sold a call option to the company that issued the bond, whether they realize it or not.

To be fair, bond indentures (specific agreements between issuers and bondholders) provide a lock-out period for the first few years of the bond’s life, where the call is not active and the bond typically trades near the price of a similar bond without a call option. For obvious reasons, issuers who need to fund their company’s operations and are issuing bonds at times of high rates, would like to call the bonds back when rates are lower in the future.

While there is no guarantee rates will fall, interest rates historically tend to rise and fall with economic cycles. To entice investors to agree to the call terms, they typically offer a premium stated coupon rate and/or bifurcating rates, so investors of all sizes can enjoy the higher rates while the bond is owned. It can also be seen as a two sided bet; bond issuers project that rates will fall or remain steady, while investors assume they will rise, stay the same or not fall enough to make it worth the issuers time to call the bonds and refund at a lower rate.

This a great tool for both parties and does not require a separate option contract. One party will be right and one wrong; whoever makes the right bet receives more attractive financing terms over long-term periods.

Putable Bonds
In contrast to callable bonds and not as common, putable bonds provide more control of the outcome within the hands of the bondholder. Owners of putable bonds have essentially purchased a put option built into the bond. Just like callable bonds, the bond indenture specifically details the circumstances for which the bond holder can adopt for the early redemption of the bond or put the bonds back to the issuer. Just like the issuer of the callable bonds, putable bond buyers make some concessions in price or yield (the embedded price of the put) to allow them to close out the bond agreements if rates rise and invest or loan their proceeds in higher-yielding agreements.

Issuers of putable bonds need to prepare financially for the possible event when investors decide putting the bonds back to the issuer is beneficial. They do this by creating segregated funds set aside for just such an event or issuing, offsetting callable bonds (like put/call strategies) where the corresponding transactions can essentially fund themselves.

There are also bonds that are putable on death, which originated with the U.S. Treasury issuing Flower Bonds allowing the bondholder’s estate and beneficiaries to redeem the bond at its par value upon death. This survivor’s option is also an inexpensive estate planning tool for investors with smaller estates, who want their assets to be immediately available to their survivors and avoid the complications of wills and trusts, etc.

The pricing of callable and putable bonds (given similar maturities, credit risk, etc.,) tend to move in opposite directions due, just like the value of the embedded put or call would move. The value of a putable bond is usually higher than a straight bond as the owner pays a premium for the put feature.

A callable bond tends to trade at lower prices (higher yields) of comparable straight bonds, as investors are not willing to pay full price since the embedded call creates uncertainty of the future cash flow from interest payments. This is why most bonds with embedded options often provide YTW (yield to worse) prices alongside their straight bond quoted prices, which reflect the YTM in the event a bond is called away by either party.

Price of callable bond = price of straight bond – price of call option

Price of putable bond = price of straight bond + price of put option

Convertible Bond
A convertible bond has an embedded option that combines the steady cash flow of a bond, allowing the owner to call on demand the conversion of the bonds into shares of company stock at a predetermined price and time in the future. The bondholder benefits from this embedded conversion option, as the price of the bond has the potential to rise as the underlying stock rises. For every upside, there is always a downside risk and for convertibles the price of the bond may also fall if the underlying stock does not perform well.

The risk reward is asymmetrical in this case, as the price of the bond will fall as the stock price falls but in the end it still has value as an interest-bearing bond, and bondholders can still receive their principle upon maturity. Of course these general rules only apply if the company remains solvent. This is why some experience in credit quality risk is important for those who choose to invest in these hybrid securities.

In the event that the company does go bankrupt, convertibles are farther down the chain in claims on company assets behind secured bondholders. On the upside, the issuing company also has the upper hand and places callable features into the bonds so investors can’t have unlimited access to the common stocks appreciation. While the issuer does have embedded brackets limiting bondholders to upside and collection upon bankruptcy, there is a sweet spot in the middle range. For example:

1. The investor purchases a bond near par and receives a market competitive coupon rate over a period of time.

2. During that time, the underlying common stocks appreciates above the previously set conversation ratio.

3. The investor converts the bond into stock trading above the conversion premium, and he/she gets the best of both worlds.

Preferred Stock
The name itself is somewhat of an anomaly as it contains both stock and bond qualities and comes in many varieties. As a bond, it pays a specified coupon and is subject to similar interest rates and credit risks as bonds. It also has stock-like features, as its value can fluctuate along with the common stock but is by no means linked to the common stock price or is as volatile.

Preferreds come in many varieties, like interest rate speculation, since they have some sensitivity to rates; but the average investor is more interested in the above-average yields. Embedded options in preferreds come in many varieties; the most common are calls, voting rights, cumulative options, where unpaid dividends accrue if not paid, conversion and exchange options.

The Bottom Line
This may be considered a brief overview of embedded options used in bonds, as there are complete series of text books covering the details and nuances. As mentioned, most investors own some sort of embedded option, whether they know it or not. They may own a long-term callable bond or own mutual funds with exposure to hundreds of these options.

The key to understanding embedded options is that they are built for specific use and are inseparable from their host security, unlike derivatives which track an underlying security. Calls and puts are the most commonly used in bonds and allow the issuer and investor to make opposing bets on the direction of interest rates. The difference between a plain vanilla bond and one with the embedded option is the price of entry into taking one of those positions. Once you master this basic tool, any embedded option can be understood.

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