Bond with credit risk = default free + short put option??

[broadex]

Could someone please explain why a “bond with credit risk can be viewed as a default free bond plus an implicit short put option written by bondholders for shareholders”??
Thanks

 

[Galli]

There’s a section in the text that describes bondholders as having a call option on the assets of the company.
I think it makes sense since a short put is pretty much a long call. Long the right to buy, short the right to sell (buy). The shareholders have a right to sell the assets (put / transfer ownership) to the bondholders, which is the same as the bondholders having the right to buy (call / transfer ownership) the assets from the shareholders.
I was trying to see if put-call parity could help describe it but I can’t make sense of it.
Po = -Co - (X/(1+Rf)
sell Po, receive Co - FV bond / Rf discount rate ?

 

[ink]

Galli wrote:
There’s a section in the text that describes bondholders as having a call option on the assets of the company.

not clear on why a bondholder has a long call option on the company. Their maximum earning is not infinite as in a call, but rather limited to interest they get.

 

[Galli]

ink wrote:

Galli wrote:
There’s a section in the text that describes bondholders as having a call option on the assets of the company.

not clear on why a bondholder has a long call option on the company. Their maximum earning is not infinite as in a call, but rather limited to interest they get.

More so related to the value of the bond not the value of the interest.
The call is only in the money when the company is unable to pay (with cash) the bondholder facevalue of the bond at maturity or if they are unable to make interest payments. Calling the assets satisfies the bond liability if the company is bankrupt.
Call doesn’t really have a payoff, it’s more like an insurance policy.

 

[sachin_patel]

lets assume company has issued bonds worth 100K to bond holders.
and its equity is 50K
so total asset value would be 150K
suppose company’s performance is so bad that its asset value declines to 30K (negative equity)
At this points, shareholder have less than they owe to bondholders.
if share holders sell those assets in open market and try to repay debt, they will get 30K for asset and will have to pay 70K out of their pockets.
instead if they default, the bond holders acquire the assets. (they have optionn to default)
they have option to sell company assets at a price of 100K.. so when actual price declines to 30K, the option is in the money and they default.
so in a way, shareholders sold 30K worth of assets to bondholders for 100K.(remaining debt)
share holders long a put option on company’s assets and bond holders are short put on company’s assets.
This is from level 2, not sure if I have explained it in a correct way.. but this is what I understood last year.

 

[ink]

sachin_patel wrote:
lets assume company has issued bonds worth 100K to bond holders.
and its equity is 50K
so total asset value would be 150K
suppose company’s performance is so bad that its asset value declines to 30K (negative equity)
At this points, shareholder have less than they owe to bondholders.
if share holders sell those assets in open market and try to repay debt, they will get 30K for asset and will have to pay 70K out of their pockets.
instead if they default, the bond holders acquire the assets. (they have optionn to default)
they have option to sell company assets at a price of 100K.. so when actual price declines to 30K, the option is in the money and they default.
so in a way, shareholders sold 30K worth of assets to bondholders for 100K.(remaining debt)
share holders long a put option on company’s assets and bond holders are short put on company’s assets.
This is from level 2, not sure if I have explained it in a correct way.. but this is what I understood last year.

thanks. this made total sense. the loss to the equity is limited to the ammount of their investment rather than to the total value of the company, so in essence they bought inssurance (long put) up to the value of the bond.