Puttable Bonds

A Puttable bond gives the investor the right to seek redemption from the issuer, usually at par, before its maturity date. This feature offers bondholders the flexibility to exit (in case the interest rate rises or the issuer’s credit rating falls) so that investors can exit from low-coupon bonds and re-invest in higher coupon bonds or better investment opportunities elsewhere.

So, for example, a 7-year bond may have a put option at the end of the 5th year. If interest rates have risen, puttable bonds allow bondholders to seek exit from the issuer before the bond’s maturity date. 

Also, note that some bonds may have both call and put options for bond issuers and bondholders respectively. The first G-Sec with both call and put option viz. 6.72% GS 2012 was issued on July 18, 2002 for a maturity of 10 years with its maturity date on July 18, 2012. The optionality on the bond could be exercised after completing 5 years tenure from the date of bond issuance on any coupon date falling thereafter. The Government has the right to buy-back the bond (call option) at par value (equal to the face value) while the investor has the right to sell the bond (put option) to the Government at par value on any of the half-yearly coupon dates starting from July 18, 2007.

When an investor buys a puttable bond, they receive interest (coupon) payments at regular intervals until the bond’s maturity date or till the investor exercises the ‘put option’. So when the market interest rate goes higher than the bond’s coupon rate, the bond’s market price would usually fall. So, instead of holding a devalued asset, bondholders can exercise the ‘put’ option and receive their full principal back and re-invest it into other bonds offering higher current yields. 

Similarly, if the bond issuer’s credit rating drops (which increases the risk of default), bondholders can exercise the ‘put’ option to redeem their investment early and preserve their capital from suffering a loss. 

As per the RBI guidelines and as published by Fixed Income Money Market and Derivatives Association of India (FIMMDA), the bonds puttable by the investor should be valued at the highest of the value/s as obtained by valuing the security to final maturity (weighted average maturity in the case of staggered redemption) and valuing the security to put option date/s.

Where bonds have simultaneous call and put options (on the same day) and there are several such calls & put options in the life of the bond, the nearest date should be taken for Price/YTM calculation.

Puttable bonds are taxed on two of its components, which are interest income and capital gains.

Capital Gains - The gains from puttable bonds will be taxed as per its holding period. An investor holding its bonds for a period of up to 12 months will be taxed under Short Term Capital Gains (STCG), which is taxed as per the tax slab rate of an investor. Long Term Capital Gains (LTCG) arise when an investor has held bonds for a duration of more than 12 months. It is taxed at 12.5% for listed bonds (without indexation benefit) and 20% for unlisted bonds. 

Interest Income - The interest income earned from a callable bond is taxed as per the income tax slab of the bondholder.