Level 1 CFA® Exam:
Callable bond vs Putable bond vs Convertible bond

There are 3 types of options that can be embedded in bonds: call options, put options, and conversion options. Therefore, we distinguish 3 types of bonds with embedded options: callable bonds, putable bonds, and convertible bonds, respectively. The value of an option influences the value of the bond.

Defining an Option

An option is a derivative instrument, which means that its value depends on the value of some underlying asset. The underlying asset can be a stock, a market index, an interest rate and so on. If an option is embedded in a bond, the value of the option depends on the price of the bond, which means that it depends on interest rates.

An option gives one party a right to buy or sell an underlying asset in the future and the other party – an obligation to sell or buy the underlying asset in the future. This means that the latter party is obligated to sell or buy the underlying in the future if the former party requests it. If the option holder decides to use his right, we say that he exercises the option.

Call Option vs Put Option

Depending on whether an option involves a right to buy or a right to sell the underlying, we distinguish two types of options:

• a call option, and
• a put option.

A call option gives the option buyer a right to buy an underlying asset in the future at a specified price from the option seller. In other words, the option seller is obliged to sell the underlying on the buyer's request.

A put option gives the option buyer a right to sell an underlying asset in the future at a specified price to the seller of the option. The seller of a put option is obliged to buy the underlying on the option buyer's request.

In the case of bonds, a put option is the right of the bondholder to sell back the bond to the issuer and the call option is the right of the issuer to buy back the bond from the bondholder.

Let’s now say a little bit more about putable and callable bonds.

Generally, there are three exercise styles of options:

• American style,
• Bermuda style, and
• European style.

American call and American put can be exercised anytime between the first call date or the first put date, respectively, and the bond maturity date. Bermuda-style options can be exercised only on given dates. Finally, European style options can be exercised only on one given date.

You should know that all characteristics of an option, such as its exercise price, lockup period, exercise style and so on, are given in the bond indenture.

In the exam, you should also remember under what conditions the party will most probably want to exercise the option. In the case of a put option, the bondholder will be eager to exercise the option if interest rates increase and the bond price decreases. In the case of a call option, the issuer will be willing to exercise the option if interest rates decrease and the bond price increases.

Sometimes there is also a conversion option embedded in the bond.

The bondholder of a bond with a conversion provision can exchange the bond for a specified number of ordinary shares issued by the issuer. A conversion option is beneficial to the bondholder (exception: CoCos) because it gives him a right and not an obligation to exchange the bond for the shares.

The terms related to convertible bonds that you should know include:

• the conversion price,
• the conversion ratio,
• the conversion value,
• the conversion premium, and
• the conversion parity.

Now let’s consider when bondholders will be interested in converting bonds into shares.

The higher the share price, the more the bondholder is likely to convert bonds into shares. Have a look at the following example.