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How Put / Call Features Affect Your Fixed-Income Portfolio

While many older Americans are afraid of the stock market with its risk and volatility, their perception of bonds and other fixed-income securities are often very different. Even though the values of many fixed-income investments fluctuate in the secondary market, the interest that they pay remains constant. Furthermore, the rates on many of these instruments are higher than those offered by banks or other traditional savings institutions.

But many investors are unaware of certain features inherent in many fixed-income securities known as “call” and “put” features. The issuer of a fixed-income security generally uses these features for one of two reasons: in order to either entice new investors or protect the issuer against a drop in interest rates. The call feature tends to fall into the latter category, while put options generally coincide with the former.

In and of itself, a “call” feature is simply a built-in provision that allows the issuer to recall the security and refund the money to its investors at a given window of time in the future (such as five years.) The issuer would do this if interest rates were much lower at the time of call than at the time of issue. For example, if interest rates were to hypothetically drop substantially by the time the call feature window opens, then the issuer will call the security. The logic behind this is obvious: why should the issuer continue to pay a higher rate to its holders when the rest of the market is paying less? Of course, the bondholders will receive their principal back in return from the call, and some issuers may even pay a premium to their investors as well.

Put features represent the other side of the coin. If a security is issued with a put feature, then the investor has the option of “putting” the security back to the issuer either at par or occasionally at a premium. This means that investors would receive not only their principal but a bonus amount as well if they turn the security back in to the issuer. This can protect investors from from being “locked” in to a lower-paying security in a rising interest rate evironment. For example, if interest rates have hypothetically risen by 3% when he exercise window of the put feature opens, then the investor will most likely turn the bonds back in to the issuer. The logic is again obvious. No investor will want to hold onto a bond paying a rate that is less than the prevailing market rate. Of course, having this option makes the bonds much more attractive to investors-and therefore much easier for the issuer to sell.

It should be noted in conclusion that a bond with a call feature will often pay a higher rate than an equivalent security that does not have this feature, and a put option will often lower the rate offered by the issuer on bonds that contain them as well.

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