What is a Death Put?
A death put is an option added to a bond that guarantees that the heirs of the deceased can sell it back to the issuer at par value. Another term for a death put is a survivor's option.
- A death put is an option added to a bond that guarantees that the heirs of the deceased can sell it back to the issuer at par value.
- A death put protects the bondholder's estate from interest rate risk.
- A bond issuer may include a death put to make it more attractive to the buyer, although the holder may have to accept a lower interest rate in return.
Understanding Death Put
As with any option, the death put gives the bondholder's estate the right, but not the obligation, to sell the bond back to the original issuer at face value in the event of the bondholder's death or legal incapacitation.
A death put is similar to a put option on a stock or other asset, in that the holder has the choice to exercise it if certain conditions are met. In this case, that condition is the death or the legal incapacitation of the bondholder. It is an optional redemption feature sold with the bond allowing the beneficiary of an estate to sell the bond back to the issuer. Proceeds from the sale become part of the estate funds.
Typically, the prices of fixed-income debt instruments and interest rates have an inverse relationship. Fixed-income investments return periodic, regular income. As interest rates increase, the open market price of fixed-income debt instruments will decrease. The death put protects the bondholder's estate when interest rates are higher than they were at the time of original purchase. Normally, a bond's coupon rate is predicated on the prevailing interest rates, so any changes in the market rates will have an effect on the value of the bond.
Bond issuers may include the death put feature to make them more attractive to the bond buyer, although the holder may have to accept a lower interest rate in return. Redemption features, such as this, put a floor under the price to protect the bondholder. Usually, it is protection from events that can have an adverse effect on the bond's value, like interest rate risk, but in this case, it is protection from interest rate risk if a very specific event—the bondholder's death—occurs.
Death Put Benefits and Caveats
The main benefit for the bondholder is that interest rate risk at the time of death is eliminated. Higher interest rates will not hurt the value of the bonds at the time of the bondholder's death.
If interest rates are lower than the coupon rate when the bondholder dies, then the price of the bond will be higher. Therefore, the estate can go into the open market to sell the bonds and receive a premium above the price that was paid (par value), just as with any bond. If, on the other hand, interest rates are higher than the coupon rate, then the market value of the bond will be below par. This is when the estate can exercise the death put option, should they choose to, to sell the bond back to the issuer at par.
Given the specialized nature of the death put, the bondholder might find it difficult to sell it while they are alive. The main problem is that the secondary market, which is where a non-standardized asset such as this is usually traded, will be limited.
Typically, early redemption happens because interest rates fell enough to make refinancing the debt a good strategy. In this case, the bondholder who already accepted a lower interest rate to start with (buying the death put) will lose the bonds and have to reinvest the proceeds at a lower interest rate.
Example of a Death Put on a Simple Bond
Assume an investor takes the option of having a death put on a $1,000 par value bond they purchase. The coupon rate is 3%, paid annually, and the bond matures in 20 years.
Five years later, the bondholder passes away. Rates on similar bonds are now yielding 5%, which means the purchased bond will be worth less than $1,000. This is because people will sell the 3% coupon bond in favor of buying a 5% coupon bond. The 3% coupon bond will fall in price until the return on the bond (below par), plus the coupon, equals 5%. At that point, new buyers will step in to prevent the price from dropping further because the yield (coupon plus capital gain) equals 5%, which is the going rate in the market.
This is the type of situation that works out well for the death put holder. The face value is below $1,000, yet the bond can be redeemed for $1,000.
If the opposite scenario occurred, and the coupon rate on similar bonds was now 2%, the 3% bond would be trading above $1,000 because it would be in demand for its higher coupon rate. Therefore, the death put is of no use. The heirs are better off selling the bond in the open market for more than $1,000.