Can someone explain callable and putable bonds? How do embedded options affect bond pricing?

Question

AcadiFi · Accepted Answer

Embedded options give one party the right to alter the bond's cash flows, and they fundamentally change how you value the bond.

**Callable Bond** — The issuer has the right to redeem the bond before maturity at a specified call price.

**Putable Bond** — The investor has the right to sell the bond back to the issuer before maturity at a specified put price.

**Pricing Impact:**

The key insight is that options have value, and who holds the option determines the price adjustment:

| Bond Type | Price Formula | Effect |
|-----------|--------------|--------|
| Callable | Price = Straight Bond Value - Call Option Value | Lower price |
| Putable | Price = Straight Bond Value + Put Option Value | Higher price |

```mermaid
flowchart TD
    A[Straight Bond Value] --> B{Embedded Option?}
    B -->|Callable| C[Subtract Call Option Value]
    B -->|Putable| D[Add Put Option Value]
    B -->|No option| E[Price = Straight Bond Value]
    C --> F[Callable Bond Price < Straight Bond]
    D --> G[Putable Bond Price > Straight Bond]
```

**Why callable bonds yield more:**
Investors demand a higher yield for callable bonds because:
1. The issuer will call when rates drop — removing the upside for bondholders
2. The investor faces **reinvestment risk** — forced to reinvest at lower prevailing rates
3. Price appreciation is capped near the call price (negative convexity)

**Example:**
Brentwood Corp issues a 5-year, 6% bond callable at $1,020 after 2 years. If rates drop to 3%, the straight bond might be worth $1,135, but the issuer calls it at $1,020. The investor loses $115 of potential gain.

**Why putable bonds yield less:**
The put option protects the investor — if rates rise and the bond's market value falls, the investor can sell back at the put price. This insurance has value, so investors accept a lower yield.

**Exam tip:** When rates increase, the call option value decreases (issuer unlikely to call), so callable and straight bond prices converge. When rates decrease, the put option value decreases (investor unlikely to put), so putable and straight bond prices converge.

Dive deeper into embedded options in our CFA Level I course materials.

Can someone explain callable and putable bonds? How do embedded options affect bond pricing?

Master Level I with our CFA Course

Related Questions

Practice Questions

Bond Type	Price Formula	Effect
Callable	Price = Straight Bond Value - Call Option Value	Lower price
Putable	Price = Straight Bond Value + Put Option Value	Higher price