A callable bond is bond in which the issuer has the right to call the bond away from the investor for a price determined at the time that the bond is issued. This amount will typically be greater than the principal amount of the bond. A puttable bond, on the other hand, allows the investor to sell the bond back to the issuer, prior to maturity, at a price that is specified at the time that the bond is issued. In the case of a callable bond, the individual with a long position in this security will essentially be long the bond and short the embedded call option. The call feature is positive for the issuer of the bond as it allows the issuer to essentially refinance debt at more favorable terms when interest rates fall. For the investor, on the other hand, this represents a drawback as it causes the price behavior of this security to exhibit negative convexity when interest rate levels fall. This limits the capital appreciation potential of the bonds when interest rates fall. Investors are usually compensated for this drawback through a greater return potential as callable bonds are usually priced at a discount to other comparable non-callable fixed income securities. By the same token, the holder of a puttable bond is essentially long the bond and long the embedded put option. This has the effect of increasing the convexity of the price-yield relationship associated with this security and thus reduces the downside risk to the investor. This has the effect of increasing the price of the security and hence reducing the potential return to the investor.
When callable/puttable bonds are issued, the terms governing the bond (frequency, coupon, maturity,) and the terms governing the embedded option such as the strike schedule are defined. The terms of the bond component are virtually identical to those of other bonds. The embedded call/put option, on the other hand, may have a lockout period associated with it (i.e. an initial period during which it cannot be called).
To evaluate an FINCAD product that can value callable and puttable bonds, contact a FINCAD Representative