Post #4 — Call, Put & Redemption Features: How Issuers and Bondholders Trade Optionality

Series: How to Read a Bond Indenture — A Value Investor’s Framework

Introduction

Most investors think bonds are simple instruments:

You lend money.
You collect a coupon.
You get par back at maturity.

That view is incomplete.

Nearly every modern bond contains embedded option contracts that quietly transfer economic value between issuer and investor. These are found in the call, put, and redemption provisions of the indenture.

If you ignore these features, you may believe you are buying a fixed return when in reality, you are selling optionality to the issuer without being paid for it.

1. The Call Option: When the Issuer Controls Your Upside

A call provision gives the issuer the right to redeem the bond before maturity at a predetermined price.

This is economically equivalent to:

The bondholder selling a call option on their own bond to the issuer.

Typical Call Structure

Non-call period (e.g., 3–5 years)
After that, callable at:
- 103
- 102
- 101
- 100 (par)

Example:

10-year bond, non-callable for 5 years, then callable at 102, stepping down to par.

Why Issuers Call Bonds

Issuers call bonds when:

Interest rates fall
Credit spreads tighten
They can refinance at a lower cost of capital

This is perfectly rational for the issuer and structurally adverse for the investor.

The moment the bond becomes most valuable to you (high price, high yield relative to market), the issuer has the right to take it away.

Investor Risk: Reinvestment Risk

When a bond is called:

You receive your principal early
You lose future high coupons
You are forced to reinvest at lower prevailing yields

This risk is most severe in falling-rate environments, when capital preservation matters most.

Analytical Rule

If a bond is callable, Yield-to-Maturity is not your return.
The economically correct return is usually Yield-to-Call (YTC).

Professional bond analysis always computes:

YTM
YTC
Yield to worst

You price the bond based on the worst outcome you don’t control.

2. Make-Whole Calls: When the Investor Is (Mostly) Protected

Some bonds contain a make-whole call, which changes the economics entirely.

Under a make-whole provision, the issuer must pay:

Present value of remaining coupons
Discounted at a Treasury rate plus a spread
Plus principal

This effectively repurchases the bond at its economic value, not at an artificial strike price like 101 or 103.

Economic Meaning

Traditional call = Issuer holds free upside
Make-whole call = Issuer must pay for that upside

For investors, this is:

A material risk reduction
A pricing stabilizer
Often seen in investment-grade issues

Make-whole calls do not eliminate reinvestment risk but they compensate you for it.

3. The Put Option: When the Bondholder Controls the Exit

A put provision gives the bondholder the right to force the issuer to repurchase the bond at specified dates, usually at par.

This is the mirror image of a call.

Economically:

The bondholder owns a put option on the issuer’s credit quality.

When Puts Matter Most

Put provisions are valuable when:

Credit deteriorates
Leverage increases
A merger weakens the balance sheet
Business risk structurally increases

They allow the investor to:

Exit before default risk is fully priced
Redeploy capital to safer instruments
Preserve principal without waiting for the secondary market

Common Examples of Put Triggers

Periodic puts (e.g., every 5 years)
Change-of-control puts (usually at 101–103)
Ratings downgrade puts
Tax or regulatory event puts

Of these, the change-of-control put is the most practically important in modern credit markets.

4. Redemption vs. Call: Important Legal Distinction

These terms are often used loosely, but they are not identical.

Feature	Who Initiates	Who Benefits	Typical Price
Call	Issuer	Issuer	Par + small premium
Put	Investor	Investor	Usually par
Mandatory Redemption	Automatic	Neutral	Par
Optional Redemption	Issuer	Issuer	Call schedule

Mandatory redemptions often arise from:

Sinking funds
Regulatory requirements
Project finance structures

These reduce default concentration risk but reintroduce reinvestment risk.

5. How Optionality Affects Bond Pricing (Quietly but Materially)

Two bonds can have:

Same issuer
Same maturity
Same coupon
Same seniority

Yet trade at very different yields purely because:

One is callable
One is not
One has make-whole protection
One has puts

The market does not price bonds based on headline yield.
It prices:

Duration convexity
Reinvestment asymmetry
Embedded option value

If you do not adjust yields for optionality, you are comparing incomparable instruments.

6. The Asymmetric Bargain

From a strict economic standpoint:

Calls benefit issuers
Puts benefit investors
Make-whole provisions split the difference
Sinking funds reduce default risk but cap return

Your job as a bond investor is to identify:

Who owns the valuable optionality and whether you are being paid for it.

A high coupon on a heavily callable bond is often not generosity it is compensation for selling convexity.

7. Practical Indenture Reading Checklist (Optionality Section)

When you reach the redemption section, locate:

First call date
Call price schedule
Whether the call is:
- Fixed-price
- Make-whole
Whether any puts exist
Change-of-control provisions
Mandatory redemption triggers
Sinking fund interaction with call features

If any of these are unclear, assume issuer-favorable asymmetry.

8. Why This Matters to Value Investors

Equity investors profit from:

Volatility
Positive convexity
Optionality

Bond investors are harmed by:

Asymmetric call risk
Unpaid reinvestment risk
Forced duration compression in falling-rate environments

Optionality determines how your bond behaves exactly when macro conditions shift.

And macro shifts are precisely when:

Capital preservation matters most
Mistakes become permanent

Next in the Series

Post #5 — Sinking Funds, Amortization & Principal Risk Over Time

We’ll examine:

Bullet vs amortizing debt
Mandatory principal retirement
How sinking funds change loss severity
Why “lower default risk” often hides “higher reinvestment risk”