What is a Put Provision
A put provision is a provision in some bonds which allows the bondholder to resell a bond back to the bond’s issuer at par or the face value of the bond before the bond matures. When the bond is purchased, the issuer will specify dates at which the bondholder may choose to exercise the put provision and redeem their bond prematurely for the bond's principal.
BREAKING DOWN Put Provision
While exercising the put provision will mean that the bondholder does not receive the full anticipated return, or yield-to-maturity,(YTM) of the investment, it does protect the bondholder from an ultimate loss on their investment. This protection is due to establishing a floor price for the bond. The floor is its principal value. If the bond’s value declines due to rising interest rates, or the deterioration of the issuer’s credit quality, a put provision will protect the bondholder from loss.
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.
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. This reluctance is because 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.
Choosing to exercise 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) for an assessment of how likely the bond’s issuer is to default. 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.
An investor may also choose to exercise the put provision if interest rates rise and they suspect that a different type of investment could ultimately be more lucrative. 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.