Many bonds include features referred to as embedded provisions. Embedded provisions give the issuer or the bondholder the right, but not the obligation, to take certain actions. Common embedded provisions include call, put, and conversion provisions.

Call, put, and conversion provisions are options, a type of derivative instrument discussed in the Derivatives chapter. The following sections describe call, put, and conversion provisions and callable, putable, and convertible bonds.

5.1 Callable Bonds

A call provision gives the issuer the right to buy back the bond issue prior to the maturity date. Bonds that contain a call provision are referred to as callable bonds.

A callable bond gives the issuer with the right to buy back (retire or call) the bond from bondholders prior to the maturity date at a pre-specified price, referred to as the call price. The call price typically represents the par value of the bond plus an amount referred to as the call premium. In general, bond issuers choose to include a call provision so that if interest rates fall after a bond has been issued, they can call the bond and issue new bonds at a lower interest rate. In this case, the bond issuer has the ability to retire the existing bonds with a higher coupon rate and issue bonds with a lower coupon rate. For example, consider a company that issues 10-year fixed-rate bonds that are callable starting 3 years after issuance. Suppose that three years after the bonds are issued, interest rates are much lower. The inclusion of the call provision allows the company to buy back the bonds, presumably using proceeds from the issuance of new bonds at a lower interest rate.

It is important to note that the call provision is a benefit to the issuer and is an adverse provision from the perspective of bondholders. In other words, the call provision is an advantage to the issuer and a disadvantage to the bondholder. Consequently, the coupon rate on a callable bond will generally be higher than a comparable bond without an embedded call provision to compensate the bondholder for the risk that the bond may be retired early. This risk is referred to as call risk.

A bond issuer is likely to exercise the call provision when interest rates fall. From the perspective of bondholders, this outcome is unfavourable because the bonds available for the bondholder to purchase with the proceeds from the original bonds will have lower coupon rates. For most callable bonds, the bond issuer cannot exercise the call provision until a few years after issuance. The pre-specified call price at which bonds can be bought back early may be fixed regardless of the call date, but in some cases the call price may change over time. Under a typical call schedule, the call price tends to decline and move toward the par value over time.

5.2 Putable Bonds

A put provision gives the bondholder the right to sell the bond back to the issuer prior to the maturity date. Bonds that contain a put provision are called putable bonds.

A putable bond gives bondholders with the right to sell (put back) their bonds to the issuer prior to the maturity date at a pre-specified price referred to as the put price. Bondholders might want to exercise this right if market interest rates rise and they can earn a higher rate by buying another bond that reflects the interest rate increase.

It is important to note that, in contrast to call provisions, put provisions are a right of the bondholder and not the issuer. The inclusion of a put provision is an advantage to the bondholder and a disadvantage to the issuer.

Consequently, the coupon rate on a putable bond will generally be lower than the coupon rate on a comparable bond without an embedded put provision. Bondholders are willing to accept a relatively lower coupon rate on a bond with a put provision because of the downside price protection provided by the put provision. The put provision protects bondholders from the loss in value because they can sell their bonds to the issuing company at the put price.

Putable bonds typically do not start providing bondholders with put protection until a few years after issuance. When a bondholder exercises the put provision, the prespecified put price at which bonds are sold back to the issuer is typically the bond’s par value.

5.3 Convertible Bonds

A conversion provision gives the bondholder the right to exchange the bond for shares of the issuing company’s stock prior to the bond’s maturity date. Bonds that contain a conversion provision are referred to as convertible bonds.

A convertible bond is a hybrid security. A hybrid security has characteristics of and relationships with both equity and debt securities. A convertible bond is a bond issued by a company that offers the bondholder the right to convert the bond into a prespecified number of common shares of the issuing company at some point prior to the bond’s maturity date. Convertible bonds are debt securities prior to conversion, but the fact that they can be converted to common shares makes their value somewhat dependant on the price of the common shares. Because the conversion feature is a benefit to bondholders, convertible bonds typically offer a coupon rate that is lower than the coupon rate on a similar bond without a conversion feature. Convertible bonds are discussed further in the Equity Securities chapter.