What does the put provision for a bond entitle the bondholder to do?
Answer
a. Allow the bondholder to sell the bond with a premium
b. Allow the bondholder to convert the bond to a put option
c. Allow the bondholder to force the bond issuer to buy back the bond
d. Allow the bondholder to retire the bond
The correct answer and explanation is:
The correct answer is c. Allow the bondholder to force the bond issuer to buy back the bond.
A put provision in a bond gives the bondholder the right, but not the obligation, to force the issuer to buy back the bond at a specified price before its maturity date. This is typically done when the bondholder believes that interest rates have risen or market conditions have changed in such a way that they would prefer to sell the bond back to the issuer rather than holding it until maturity.
The put provision is beneficial for the bondholder because it provides a level of protection in adverse market conditions. For example, if interest rates rise after the bond is issued, the value of the bond in the secondary market may decrease. In such cases, the bondholder can exercise the put provision to sell the bond back to the issuer at a pre-determined price, usually at par value or a slight premium, regardless of market conditions.
This feature contrasts with a call provision, which allows the issuer to buy back the bond from the bondholder before maturity, typically when interest rates fall and the issuer can refinance the debt at a lower cost. The put provision shifts the advantage to the bondholder, offering them flexibility to exit the investment under certain conditions.
In practice, put provisions are not common in all bonds, and those that include this feature tend to have lower yields compared to bonds without it. The added protection of a put option lowers the risk for the bondholder, and thus, the bond issuer may offer a slightly lower interest rate as compensation for the additional benefit granted to the bondholder.