What Are Putable Bonds?

Putable bonds are debt securities that include a put option enabling the bondholder to demand a return of principal prior to the maturity date. Many investors view putable bonds as safer investments than standard debt securities because of the relatively high level of liquidity that these bonds provide. Nevertheless, putable bonds have some downsides, including the fact that these bonds pay lower rates of interest than comparable bonds that lack a put option.

Bonds and other types of debt securities are actually loans and the investors who buy these bonds are the creditors of the bond issuer. Like most loans, bonds have term times that can last for up to 30 years. During the bond term, the issuer pays interest on the debt and this interest may be added to the bond's value or disbursed to the bondholder on a monthly, quarterly, semi-annual or annual basis. When the bond reaches maturity, the bond issuer makes a one-time principal payment to the bondholder. Holders of putable bonds do not have to wait until maturity to get this lump sum principal payment.

The holder of a putable bond can only exercise the put option on specific dates that are detailed in the original bond purchase agreement. In many instances, bondholders can activate the put option on the anniversary of the bond issue date while in other situations bondholders have several windows of opportunities to redeem the bond over the course of a single year. Putable bonds are more liquid than other types of bonds and in the investment arena people earn more when they sacrifice liquidity. Therefore, a bond issuer would pay a lower rate of interest on a five-year putable bond than on a five-year bond that did not have an early redemption option.

Putable bonds, like other investments, expose people to various risks; this includes principal risk. If a large number of bondholders activate put options at the same time, the bond issuer may lack sufficient funds to repay the debts. A bond issuer that cannot repay its debts is technically insolvent and such entities often end up filing bankruptcy. Bondholders like other creditors may lose their entire investment if a bond issuer goes bankrupt.

Municipal governments and corporate entities issue putable bonds and in many instances, these bonds are marketable which means that the original purchaser can sell the bond to another investor. The prices of bond fluctuate over time because rising interest rates cause older low-yield bonds to become less attractive to investors while the opposite occurs when rates fall. Depending on market conditions, the owner of a putable bond could potentially sell a bond to another investor for more than its actual purchase price.