What does it mean when a bond has a put option?

A put option on a bond, also known as a put provision, gives the holder the right to demand the issuer pay back the principal before the bond matures, for whatever reason.

There are several reasons why a bond holder might exercise a put provision on a bond. The holder might feel the issuer's business and finances are weakening, thus jeopardizing its ability to pay off debt. Interest rates may have risen since the bond was initially purchased, and the investor wants to recover principal to redeploy cash to investments that can earn a higher return.

Another benefit to a bond with a put provision is it removes the pricing risk holders face when they attempt to sell the bond in the secondary market, where they may be forced to sell at a discount. The provision adds an extra layer of security for bond holders, as it gives them a safe exit strategy. Because the put provision is favorable to bond holders, the bond will be sold at a premium compared with bonds lacking the option.

Bonds with a put option are referred to as put bonds or putable bonds. This is the opposite of a callable bond, in which the issuer may redeem an outstanding bond before it reaches maturity. Terms and details of putable and callable bonds are discussed in the bond's indenture.

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