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B. Venkatesh

SEBI, in its recent concept paper, has proposed that companies issue bonds with put options. What does the proposal mean to bond investors?

Such bonds will enable investors to sell the instrument back to the company at a pre-determined price. A company may, for instance, issue a 10-year bond with a put option at a strike price of Rs 100 exercisable after five years. This gives the investors the right to sell the bond back to the company after five years at Rs 100 per bond. The investor will do this only if the bond price falls below Rs 100.

Now, SEBI has proposed the issue of such bonds to prevent companies from taking decisions that may be detrimental to the bondholders. Suppose a company increases dividend payouts to equity holders. The company may not have enough cash flows to pay interest to bondholders.

Besides, increasing dividends reduces reserves, and, therefore, the company's networth. That may increase the debt-equity ratio, which is not good for the bondholders. The bond price may decline, causing losses to the bondholders.

A put option gives the bondholders a choice to sell the bond at a certain rate to prevent such losses. Companies benefit too because such bonds carry lower interest rates than comparable bonds without put options.

How do bonds with put options behave to interest rate changes? Suppose the interest rate declines. Bond prices will increase because of the inverse price-yield relationship. But bonds with put options will not increase as much as bonds without options. Why?

The reason is that bonds without put options carry a higher rate than bonds with put options. So, investors will prefer the bonds without options when the interest rate declines. The increased demand will push up the price of those bonds more than bonds with put options.

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