How does a put option create a floor price for putable bonds?

A putable bond gives the bondholder the right to sell (put) the bond back to the issuer at a specified price (usually par) on certain dates. This put option creates a floor below which the bond's price will not fall, regardless of how high yields go.

Value Relationship:

> Putable Bond Value = Non-Putable Bond Value + Put Option Value

The put option always has non-negative value, so a putable bond is always worth at least as much as an identical non-putable bond.

Example — Fairview Municipal 4% Putable at Par (fictional):

When yields are below the coupon rate, the put option is 'out of the money' — the bond is worth more than par, so the holder would never exercise. When yields rise above the coupon, the non-putable bond falls below par, but the putable bond stays at par because the holder can exercise the put.

Price-Yield Behavior:

• At low yields: putable and non-putable bonds behave identically (positive convexity)
• At high yields: the putable bond's price levels off at the put price, creating a floor
• The putable bond exhibits enhanced positive convexity at high yields — it declines less than expected

Investor Benefits:

1. Downside protection in rising rate environments
2. Reduced effective duration at high yields (expected life shortens to put date)
3. Lower price volatility compared to non-putable bonds

Cost: Putable bonds have lower yields than comparable non-putable bonds because the investor is paying for the put option through a lower coupon.

Exam Tip: Remember the symmetry — callable bonds benefit issuers (ceiling on price), putable bonds benefit holders (floor on price). The CFA exam often pairs these concepts.

Practice embedded option analysis in our CFA Level I bank.