A Beginner's Guide to Embedded Options in Bonds

Investors are constantly challenged with learning about and keeping current on a number of financial-related issues such as the volatile world of international investing, currency swings, creative accounting, bankruptcies, or the complex world of derivatives. One particular concept in investing that sounds complicated, but once broken down isn't that complex — embedded options are owned by many investors, whether they realize it or not.

Once the basic concepts and some simple rules are mastered, an investor should be able to understand even the most complex embedded options. In the broadest terms, embedded options are components built into the structure of a financial security that provide the option of one of the parties to exercise some action under certain conditions.

Each investor has a unique set of income needs, risk tolerances, tax rates, liquidity needs and time horizons — embedded options provide a variety of solutions to fit all participants. Embedded options are more commonly found in bonds and preferred stocks, but can also be found in stocks. There are as many varieties of embedded options as there are needs for issuers and investors to alter the structures of their agreements — from calls and puts to cumulative payouts and voting rights, and one of the most common, conversions.

While embedded options are inseparable from their issue, their value can be added or subtracted from the core securities price just like traded or OTC options. Traditional tools like the Black-Scholes option pricing model and the Black-Derman-Toy model can be used to value the options, but the average investor can estimate the value on a callable bond as the spread between the yield to call (YTC) and yield to maturity (YTM).

Embedded options are found more often in bonds due to the sheer size of the bond market and the unique needs of issuers and investors. Some of the most common forms used in bonds includes:

Callable bonds are a tool used by issuers, especially at times of high prevailing interest rates, where such an agreement allows the issuer to buy back or redeem bonds at some time in the future. In this case, the bondholder has essentially sold a call option to the company that issued the bond, whether they realize it or not.

To be fair, bond indentures (specific agreements between issuers and bondholders) provide a lock-out period for the first few years of the bond’s life, where the call is not active and the bond typically trades near the price of a similar bond without a call option. For obvious reasons, issuers who need to fund their company’s operations and are issuing bonds at times of high rates, would like to call the bonds back when rates are lower in the future.

While there is no guarantee rates will fall, interest rates historically tend to rise and fall with economic cycles. To entice investors to agree to the call terms, they typically offer a premium stated coupon rate and/or bifurcating rates, so investors of all sizes can enjoy the higher rates while the bond is owned. It can also be seen as a two-sided bet; bond issuers project that rates will fall or remain steady, while investors assume they will rise, stay the same or not fall enough to make it worth the issuer's time to call the bonds and refund at a lower rate.

This a great tool for both parties and does not require a separate option contract. One party will be right and one wrong; whoever makes the right bet receives more attractive financing terms over long-term periods.

In contrast to callable bonds (and not as common), putable bonds provide more control of the outcome for the bondholder. Owners of putable bonds have essentially purchased a put option built into the bond. Just like callable bonds, the bond indenture specifically details the circumstances a bondholder can utilize for the early redemption of the bond or put the bonds back to the issuer. Just like the issuer of the callable bonds, putable bond buyers make some concessions in price or yield (the embedded price of the put) to allow them to close out the bond agreements if rates rise and invest or loan their proceeds in higher-yielding agreements.

Issuers of putable bonds need to prepare financially for the possible event when investors decide putting the bonds back to the issuer is beneficial. They do this by creating segregated funds set aside for just such an event, or issuing offsetting callable bonds (like put/call strategies) where the corresponding transactions can essentially fund themselves.

There are also bonds that are putable on death, which originated with the U.S. Treasury issuing Flower Bonds that allow for the bondholder’s estate and beneficiaries to redeem the bond at its par value upon death. This survivor’s option is also an inexpensive estate planning tool for investors with smaller estates who want their assets to be immediately available to their survivors and avoid the complications of wills and trusts, etc.

The pricing of callable and putable bonds (given similar maturities, credit risk, etc.) tend to move in opposite directions, just like the value of the embedded put or call would move. The value of a putable bond is usually higher than a straight bond as the owner pays a premium for the put feature.

A callable bond tends to trade at lower prices (higher yields) of comparable straight bonds, as investors are not willing to pay full price since the embedded call creates uncertainty of the future cash flow from interest payments. This is why most bonds with embedded options often provide yield to worst (YTW) prices alongside their straight bond quoted prices, which reflect the YTM in the event a bond is called away by either party.

Price of callable bond = price of straight bond – price of call option

Price of putable bond = price of straight bond + price of put option

A convertible bond has an embedded option that combines the steady cash flow of a bond, allowing the owner to call on-demand the conversion of the bonds into shares of company stock at a predetermined price and time in the future. The bondholder benefits from this embedded conversion option as the price of the bond has the potential to rise when the underlying stock rises. For every upside there is always a downside risk, and for convertibles the price of the bond may also fall if the underlying stock does not perform well.

In this case the risk/reward is asymmetrical as the price of the bond will fall as the stock price falls, but in the end it still has value as an interest-bearing bond — and bondholders can still receive their principal upon maturity. Of course these general rules only apply if the company remains solvent. This is why some experience in analyzing credit quality risk is important for those who choose to invest in these hybrid securities.

In the event that the company does go bankrupt, convertibles are farther down the chain in claims on company assets behind secured bondholders. On the upside, the issuing company also has the upper hand and places callable features into the bonds so investors can’t have unlimited access to the common stock's appreciation. While the issuer does have embedded brackets limiting bondholders to upside and collection upon bankruptcy, there is a sweet spot in the middle range.

For example:

1. The investor purchases a bond near par and receives a market competitive coupon rate over a period of time.

2. During that time, the underlying common stock appreciates above the previously set conversion ratio.

3. The investor converts the bond into stock trading above the conversion premium, and they get the best of both worlds.

The name preferred stock is somewhat of an anomaly as it contains both stock and bond qualities and comes in many varieties. As a bond, it pays a specified coupon and is subject to similar interest rates and credit risks as bonds. It also has stock-like features, as its value can fluctuate along with the common stock but is by no means linked to the common stock price, or is as volatile.

Preferreds come in many varieties, like interest rate speculation, since they have some sensitivity to rates. But the average investor is more interested in the above-average yields. Embedded options in preferreds come in many varieties; the most common are calls, voting rights, cumulative options where unpaid dividends accrue if not paid, conversion and exchange options.

Think of this as a brief overview of the types of embedded options used in bonds, as there are complete series of textbooks and online resources covering the details and nuances. As mentioned, most investors own some sort of embedded option and may not even be aware. They may own a long-term callable bond or own mutual funds with exposure to hundreds of these options.

The key to understanding embedded options is that they are built for specific use and are inseparable from their host security, unlike derivatives which track an underlying security. Calls and puts are the most commonly used in bonds and allow the issuer and investor to make opposing bets on the direction of interest rates. The difference between a plain vanilla bond and one with the embedded option is the price of entry into taking one of those positions. Once you master this basic tool, any embedded option can be understood.