Put Risk

Put risk is the risk that an embedded put option in a security is exercised, typically by the security holder, forcing you into an unfavourable transaction or preventing a profitable exit. It is less common than call-risk but occurs in some bonds, preferred stocks, and structured products.

How put options embedded in securities work

A putable bond gives the bondholder the right (but not the obligation) to force the issuer to buy back the bond at a specified price on certain dates. This is the opposite of a call-risk, where the issuer forces the bondholder.

Example: A bank issues a 10-year putable bond with a 3% coupon. The bondholder has the right to put (sell back) the bond to the bank at par (100) on specified dates — say, every 2 years. If the bank’s credit quality deteriorates and the bond falls in value, the bondholder can exercise the put, forcing the bank to buy it back at par, locking in a loss for the bank (which must buy back a bond that would trade below par in the open market).

Why put options are embedded in securities

Issuers embed put options to attract buyers when the securities are risky or when conditions are uncertain:

• Preferred stocks with rate reset features. The issuer sets a new dividend rate every 5 years; if the rate is set too low, the preferred holder can put the stock back.

• Floating-rate bonds. If interest rates rise and the floating coupon does not rise enough (due to a cap), holders might have a put to force the issuer to buy back the bond.

• Putable bonds with call protection. To compensate the bondholder for long call protection (no call for 10 years), the issuer grants a put option, allowing the holder to exit if conditions change.

The put option reduces the issuer’s credit risk from the bondholder’s perspective (if credit deteriorates, they can put), but it increases the issuer’s refinancing risk and liquidity risk (they must have capital available to buy back bonds if puts are exercised).

Put risk for the issuer

From the issuer’s perspective, put risk is the danger that:

• The bond or preferred stock falls in value, making the put valuable.
• The holder exercises the put, forcing the issuer to buy back at par when the market value is lower.
• The issuer must find cash to buy back the securities, straining liquidity during a crisis when it is needed most.

This is why put options are costly for issuers and why they are used only when necessary to attract buyers.

Put risk for the holder

Put risk for the bondholder or preferred holder is more subtle:

• Capped upside. If you buy a putable bond with an embedded put and interest rates fall, the bond price rises. But you may be unable to sell above the put price due to the put floor. The put option prevents large gains if conditions improve.

• Forced timing. You wanted to hold the bond longer, but the issuer’s credit deteriorates sharply. The put is now valuable and other holders exercise, flooding the market with put-backs. The issuer might restrict the put or impose conditions, or it might be unable to buy back all the bonds, creating a crisis.

• Refinancing risk. If you put a bond back and receive par, you must reinvest the proceeds in a market where rates have potentially changed. You are forced out at a specific time, not by choice.

Typically, put options in fixed-income securities are valuable to the holder, not the issuer. A bondholder holding a putable bond has a one-way bet: if rates fall or credit improves, hold the bond and enjoy gains. If rates rise or credit deteriorates, exercise the put and minimize losses. This asymmetry means putable bonds are typically cheaper (lower yield) than non-putable bonds.

Managing put risk

For issuers, put risk is managed by:

• Limiting put dates and prices. Allow puts infrequently and at reasonable (not par) prices.
• Maintaining liquidity. Keep cash or credit lines available to buy back puts if exercised.
• Monitoring credit risk. Refinance before credit deteriorates enough to make puts attractive to exercise.

For investors holding securities with embedded puts:

• Understand the put terms. Know when the put can be exercised, at what price, and under what conditions.
• Monitor issuer credit. If the issuer’s credit deteriorates, the put becomes more valuable and likely to be exercised.
• Factor in the put value. Use option pricing models to value the embedded put and adjust your expected return accordingly.

For most individual investors, put risk is a detail encountered in specialized fixed-income securities. The main insight is that put options create asymmetry in both directions: they are valuable to security holders (and thus priced into lower yields or higher prices) but represent refinancing risk for issuers.

See also