Classification of Fixed Income Securities Based on Embedded Options

Options and derivatives are generally associated with equity securities. That’s why investors are unaware that they can also invest in bonds with embedded options. Options have the potential to change the risk profile of the bonds being issued. In this blog, we will talk about fixed-income securities based on embedded options.

How Do Embedded Options Work?

Fixed income security is a contract between two parties and the investors hand over their money to the company for a fixed period of time. In normal cases, both parties cannot walk away from the contract till the security matures. But embedded options in fixed-income securities allow both parties with the option to end the contract before it matures if it is favorable for them.

Classification of Fixed Income Securities Based on Embedded Options

1. Straight Bonds: These are also known as Vanilla bonds. A straight bond pays fixed interest at regular intervals and pays back the principal on maturity. For example, a corporation issued an Rs. 1,000 face-value discount bond with a maturity of 10 years and the interest rate is 5%; bondholders will earn 5% x Rs. 1,000 = Rs. 50 every year till the bond matures i.e. for 10 years.

2. Callable Bonds: A callable bond is beneficial for the company issuing the bond because it gives the company a right to call back the bonds from investors before it matures. This means the company can return the outstanding principal to the investors and end the contract. In such bonds, the price is mentioned in reference to a base price, or the absolute price can be mentioned in the agreement. Callable bonds are advantageous for the company since the company can avoid paying excess interest. For example, a corporation may have issued callable bonds for 10 years at 12% p.a. But at the end of 6th year, let’s say the interest rate in the open market falls to 8%. In such cases, the company can exercise its right to pay back the principal amount to the bondholders and issue a new bond using the 8% interest rate.

3. Puttable Bonds: These are the exact opposite of callable bonds. Puttable bonds provide the same power to the investors to cancel the contract before it matures. The bond indenture has guidelines about the price at which the investor can sell the bond. Let’s say the investor would have lent out money when the interest rate was 8%, but let’s assume the market rate may have increased to 12%. In this case, the investor would now be earning a lower rate of return, and the investor can exercise his put option and end the contract before maturity.

4. Convertible Bonds: It is a hybrid debt instrument that includes the feature of both debt and equity. This bond allows the investor a right to convert the bond into equity shares of the issuing company. The quantity and the value of shares are predetermined and are mentioned in the contract. Once these bonds are converted into equity shares, the bondholders become the company’s shareholders. The investor can convert the bonds into equity shares only during the bond’s tenure. However, convertible bonds offer similar features like regular corporate bonds and provide periodic interest payouts at fixed intervals in case the investor wishes not to convert the bonds into equity shares. These bonds offer lower coupon rates than corporate bonds because of their convertible nature. For example, a ratio of 5:1 means that one bond would convert to five shares of equity shares.

5. Warrants: It is a bond with option rights. For a specific time, it provides the right to buy equity shares, including shares of the bond issuer, at a fixed price. These are derivative instruments like options that give the right to the investor to buy equity shares of the issuing company at a specific price before the expiration. It has a strike or exercise price as these are options contracts. A warrant can be American or European. An American Warrant can be exercised anytime before or on the expiration date, but a European warrant can only be exercised on the expiration date. They are traded in the Over the Counter (OTC) market. They are issued as a supplement to the bondholders, allowing the bond issuer to offer a lower coupon rate. They can be separated from the bonds and traded in the secondary markets.

Frequently Asked Questions (FAQs)