Common Options Embedded in a Bond Issue

The following kinds of options are an integral part of the bond issue, and are not considered a separate security.

Security Owner Options 

The option embedded in a fixed income security is an option granted to the security holder or lender, and gives an additional value to the security compared to the identical straight option, which is option free.

  • A conversion option offers the right to the bond holder to convert the security to a fixed number of shares at a later date, after the lapse of a period mentioned. This choice carries some value for the bond holder. However, the exchange option, or conversion option allows the option for the bond holder to convert the bonds only to convert them into common shares.
  • A put option gives bond holders the right to sell the bond to the issuer at a later date, which is specified in the terms at the time of issue of the bonds. Such a put price is generally closer to par value if the bonds are initially issued at a par value. Usually, a bond holder exercises the put option if the interest rates are on a rise, or alternately, if the credit worthiness of the bond issuer has fallen since the time of issue of bond.
  • Floors set a minimum coupon rate on the bond, in case of a floating rate security or bond, where the interest rate is subject to change with the Libor rates in common, and may decrease in case of fall of Libor rates, or vice versa.

Security Issuer Options

These options are meant for the security issuers.

  • Call provisions gives bond issuer the right to redeem the security ahead of its maturity date, in one shot or in trenches, after lapse of an initial non-callable period.
  • Prepayment options are included in many amortized securities, which offer the right to the borrower to repay the liability ahead of the initial tenure of loan. A complete prepayment allows him to get the mortgaged asset released from the lender at that date, when he settles the entire outstanding liability.
  • Embedded sinking fund options are such options held by the issuer of bond, which allow the issuer to annually retire part of the large proportion of an issue, upto a specified limit.
  • Caps set a maximum coupon rate for a floating rate security or bond, which is pegged on the Libor rates, and could rise in case of increase in Libor. The issuer knows the maximum limit of coupon liability he may need to pay as interest, once the cap is set in advance.