Call and Put Options in Bonds
Callable bonds give the issuer the right to redeem the bond before maturity at a specified call price, while putable bonds give the investor the right to sell the bond back to the issuer at a predetermined price, with both embedded options altering the bond's duration and yield profile.
In the Indian fixed income market, callable bonds are far more common than putable bonds. The issuer's call option is economically equivalent to the issuer having purchased a call option on interest rates — if rates fall, the issuer calls the bond, refinances at lower cost, and the investor bears reinvestment risk. If rates rise, the issuer holds the bond outstanding, and the investor is locked into a below-market coupon.
AT1 bonds issued by banks are perpetual but typically carry periodic call options — commonly every 5 years post-issuance. The market convention developed an assumption that well-capitalised banks would call these instruments at the first call date, an assumption that the Yes Bank episode in 2020 disrupted significantly. When Yes Bank's AT1 bonds were written down, the market re-priced the optionality and credit risk of AT1 instruments sector-wide.
For standard corporate NCDs and non-bank bonds, issuers may include a 'call option after X years' clause to retain the flexibility of refinancing if rates decline. A callable bond's yield will be higher than an equivalent non-callable bond from the same issuer to compensate investors for the reinvestment risk associated with a potential early redemption — this difference is known as the 'call premium.'
The analytical framework for pricing callable bonds uses option-adjusted spread (OAS) — the spread over the benchmark yield curve after removing the value of the embedded option. OAS allows comparison across bonds with and without embedded options on an apples-to-apples basis. OAS models require an interest rate model (such as the Black-Derman-Toy or Hull-White model) and Monte Carlo simulation of possible rate paths.
The putable bond, while less common in India, was used by some issuers in the early 2000s to attract risk-averse investors who wanted downside protection if credit quality deteriorated. The investor's put option has value in rising rate environments — allowing exit at par rather than at a market discount. The issuer compensates for granting this option by offering a lower coupon than a comparable non-putable bond.