Bottom of Pg 81 in Fixed Income CFA Book (paraphrased by me): “For putable structures, implied volatility is around 10% lower than that of callables…this divergence in implied volatility suggests that asset managers, driven by a desire to boost portfolio yield, UNDERPAY issuers for the right to put a debt security back to the issuer…in other words the typical put bond should trade at lower yield in the market than is commonly the case….this structure should be favored as an outperformance vehicle only by those with a decidely bearish outlook for interest rates” Can someone please make sense of this for me? Thanks in advance
Divergence in implied volatility for putable and callable - help
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S2000magician
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Put options have lower implied volatilities than call options.
Therefore, put options have lower prices than call options.
Therefore, a putable bond, which is equivalent to a long option-free bond and a short long put option, sells at a higher lower price than one should expect.
Therefore, a putable bond has a lower yield than one should expect (i.e., it should have a higher YTM, but it doesn’t).
Therefore, one should buy such a bond only when one expects interest rates to fall, to benefit from the price appreciation.
Therefore, put options have lower prices than call options.
Therefore, a putable bond, which is equivalent to a long option-free bond and a short long put option, sells at a higher lower price than one should expect.
Therefore, a putable bond has a lower yield than one should expect (i.e., it should have a higher YTM, but it doesn’t).
Therefore, one should buy such a bond only when one expects interest rates to fall, to benefit from the price appreciation.
Doesnt’ this also have something to do with credit risk. You’d want to use your put if rates went up, and your bond dropped in value, but if rates go up, the issuers of these puttable bonds might not be able to deliver on their promise to pay you back at the strike price (because they are now having to refinance at higher rates). So the put isn’t worth as much as it “should” be worth.
S2000magician
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That could very well be the reason for the lower implied volatility.cleverCFA wroteoesnt’ this also have something to do with credit risk. You’d want to use your put if rates went up, and your bond dropped in value, but if rates go up, the issuers of these putable bonds might not be able to deliver on their promise to pay you back at the strike price (because they are now having to refinance at higher rates). So the put isn’t worth as much as it “should” be worth.
iamthenight
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correct me if im wrong S2000
a putable bond is LONG option free bond and LONG put option??
if the above is correct, we buy putable bonds becos we want to sell the bond at a certain price (if price falls, aka interest rates rise??)
iamthenight - you are confusing between a Putable bond and a Protective put strategy on the Bond.
a Putable Bond price = Price of Non Putable Bond (Option free) - Price of Put Option.
while a Callable Bond Price = Price of Non-callable bond (Option free) + Price of Call Option.
a Putable Bond price = Price of Non Putable Bond (Option free) - Price of Put Option.
while a Callable Bond Price = Price of Non-callable bond (Option free) + Price of Call Option.
Damodaran page 33: http://people.stern.nyu.edu/adamodar/pdfiles/valn2ed/ch33.pdf.
The issuer has the advantage of calling the bond, that is, you as an investor are at a disadavantage. There’s no way I’m paying more for that kind of liberty. In the case of a put bond, the investor has an advantage in that he can put the bond back on the issuer. So the investor must pay extra for such an “option” - so the price of the put is added to the selling price.
The issuer has the advantage of calling the bond, that is, you as an investor are at a disadavantage. There’s no way I’m paying more for that kind of liberty. In the case of a put bond, the investor has an advantage in that he can put the bond back on the issuer. So the investor must pay extra for such an “option” - so the price of the put is added to the selling price.
S2000magician
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Oops. You’re right. Thanks!iamthenight wrote:
correct me if im wrong S2000S2000magician wroteut options have lower implied volatilities than call options.
Therefore, put options have lower prices than call options.
Therefore, a putable bond, which is equivalent to a long option-free bond and a short put option, sells at a higher price than one should expect.
Therefore, a putable bond has a lower yield than one should expect.
Therefore, one should buy such a bond only when one expects interest rates to fall, to benefit from the price appreciation.
a putable bond is LONG option free bond and LONG put option??
if the above is correct, we buy putable bonds becos we want to sell the bond at a certain price (if price falls, aka interest rates rise??)
I’ve revised my thinking, and edited my original post.
As a holder of a put bond, you have the option to put the bond back to the issuer at par. You have the option to sell the bonds to the issuer at a strike of $100, this is being long a put option. Since the implied volatility is lower than that of a callable bond, this put is CHEAPER relative to the price of a call on a callable bond. Putable bond has a higher yield then one should expect and you would buy this bond when we expect interest rates to rise so we have the option to put the bond back at par if the price drops below.
S2000magician
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The original quote says that putable bonds trade at a lower yield than one would expect, not a higher yield.
The price of a putable bond will never drop below the put price.
please re read his comment
“this divergence in implied volatility suggests that asset managers, driven by a desire to boost portfolio yield, UNDERPAY issuers for the right to put a debt security back to the issuer…in other words the typical put bond should trade at lower yield in the market than is commonly the case….”
the typical put bond should trade at a lower yield, which means they trade at a higher yield. This is because the price is lower than it should because implied volatility is lower than that of a callable bonds.
how about a 20yr zero coupon bond puttable in 10yrs at Par?? Puttable bonds trade at discounts all the time, they are priced to the put date, similar to a callable bond trading at a high premium that gets priced to the call date.
“this divergence in implied volatility suggests that asset managers, driven by a desire to boost portfolio yield, UNDERPAY issuers for the right to put a debt security back to the issuer…in other words the typical put bond should trade at lower yield in the market than is commonly the case….”
the typical put bond should trade at a lower yield, which means they trade at a higher yield. This is because the price is lower than it should because implied volatility is lower than that of a callable bonds.
how about a 20yr zero coupon bond puttable in 10yrs at Par?? Puttable bonds trade at discounts all the time, they are priced to the put date, similar to a callable bond trading at a high premium that gets priced to the call date.
S2000magician
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I’d misunderstood your comment; I was thinking about the price of the bond once the put option is exercisable: after 10 years your 20-year zero wouldn’t trade below par.
iamthenight
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np s2000. was reading up on this topic
i thought that the putable bond should sell at a premium to the option free bond?? what is the bond to be compared to when u said “lower price”?
lower yield for the putable bond is expected since we have splashed out more for the put option?
putable bond is bought when we expect the rates to rise?? interest rates rise -> bond price drop -> put option allows us to sell the bond at a pre-determined price.
S2000magician
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A low price than would be expected if the implied volatility of the put option were as high as the implied volatility of a comparable call option. In short, put options are priced lower than one would expect.iamthenight wrote:
np s2000. was reading up on this topicS2000magician wrote
Therefore, put options have lower prices than call options.
Therefore, a putable bond, which is equivalent to a long option-free bond and a short long put option, sells at a higher lower price than one should expect.
Therefore, a putable bond has a lower yield than one should expect (i.e., it should have a higher YTM, but it doesn’t).
Therefore, one should buy such a bond only when one expects interest rates to fall, to benefit from the price appreciation.
i thought that the putable bond should sell at a premium to the option free bond?? what is the bond to be compared to when u said “lower price”?