What is Put Provision?
- A put provision allows a bondholder to resell a bond back to the issuer at par, or face value, after a specified period but prior to the bond's maturity date.
- Put provisions protect bondholders from reinvestment risks and issuer default.
- A put provision is to the bondholder what a call provision is to the bond issuer.
Understanding Put Provision
Essentially, a put provision is to the bondholder what a call provision is to the bond issuer. When a bond is purchased, the issuer will specify dates at which the bondholder may choose to exercise the put provision and redeem their bond prematurely to receive the principal amount. A put provision will generally specify multiple dates when the bond may be redeemed before the maturity date. Multiple dates provide the bondholder with the ability to reassess their investment every few years, in the event, they wish to redeem for reinvestment.
Exercising the put provision will mean that the bondholder does not receive the full anticipated return, or yield-to-maturity (YTM) of the investment. However, it does offer protection to the bondholder from suffering undesirable losses on their investment. For example, If the bond’s value declines due to rising interest rates, or the deterioration of the issuer’s credit rating, a put provision will protect the bondholder from the potential losses emanating from these events. This protection is due to the establishment of a floor price for the bond, which is its principal value.
However, if the bondholder purchased the bond when interest rates were high, and interest rates have since dropped, it’s unlikely that the bondholder would want to exercise the put provision since their fixed-income investment is still earning the same higher rate of return. If they were to redeem the bond and reinvest into another fixed-income security, they would, most likely, have a lower yield, due to the lower available interest rates. Also, the investor may prefer to continue receiving the bond’s payment coupons in favor of merely collecting the one-time principal payment by redeeming.
Exercising a Put Provision
An investor will likely exercise the put provision in a bond if they have reason to believe that the bond’s issuer will default on payment when the bond comes to maturity. An investor can look to rating agencies such as Moody’s and Standard & Poor’s (S&P) to get an assessment of the bond issuer's default probability. However, it’s worth noting that many bonds with put provisions are guaranteed by third parties, such as banks. Thus, if an issuer is unable to make its payments on redeemed bonds, the bondholder can still be guaranteed payment by the third party.
Put provisions protect the bondholder from reinvestment risk. Say interest rates rise and the bondholder suspects that a different type of investment could ultimately be more lucrative than the one they currently own. They could exercise the put provision and redeem this bond to reinvest in the other instrument. For example, a bondholder may purchase a bond when interest rates are at 3.25%. However, if interest rates rise to 4.75%, they may start to consider their bond’s rate of 3.25% undesirably low and want to redeem it, so as to reinvest it at the current higher interest rate.