What is Retractable Bond?
Retractable bond, also known as variable-rate demand note, is a debt security that features a put option which allows the holder to force the issuer to redeem the bond before maturity at its face value.
- Retractable bond, also known as variable-rate demand note, is a debt security that features a put option which allows the holder to force the issuer to redeem the bond before maturity at it's face value.
- The inclusion of the put option, allows the bondholder the right to cash in on the retractable bond’s principal once the lock-out period ends.
- Retractable bond is equal to its cash flows plus the value of the put feature.
Understanding Retractable Bond
The inclusion of the put option, allows the bondholder the right to cash in on the retractable bond’s principal once the lock-out period ends. Basically, a retractable bond can protect an investor from interest rate risk. An investor may choose to shorten the maturity on a bond due to adverse market conditions or if they require the principal sooner than anticipated. Retractable bond is sometimes referred to as a put bond, putable bond or puttable bond.
A retractable bond’s put feature sets a base limit on the bond price, irrespective of the increase in interest rates before its maturity date. Initially, the rule of thumb was that retractable bonds were issued at 0.2% less in yield than a regular bond of the same issuer. More recently, with the growth of options and swap markets, these bonds are priced using options pricing techniques.
To determine a retractable bond’s price the value of the underlying debt must first be determined using the discounted cash flow (DCF) approach. The put feature is then measured as the benefit of holding or exercising the embedded option using options pricing modeling. This pricing method is the basis of the value of the debt at various option valuation dates up to the bond’s maturity point. Therefore, a retractable bond is equal to its cash flows plus the value of the put feature.
The opposite of a retractable bond is an extendable bond. They function in much the same way as retractable bonds only they extend the initial maturity to a longer maturity date. Investors use both retractable and extendable bonds to amend the terms of their portfolios to take advantage of changes in interest rates.
Retractable Bond Benefit
Suppose a company issues 20-year retractable bonds to the market. This retractable position means the investor who buys the bond from the issuer has the right to receive the par value, or face value, of the bond at any time before its maturity date. If the investor exercises the right to retract, they will forfeit the remaining coupon payments on the bond.
An investor might exercise the retraction option due to unfavorable economic conditions such as a rise in interest rates. An increase in interest rates would translate into lower bond prices. As a result, the bondholder could reinvest the funds received from exercising the retractable bond into a higher-yielding bond.