"Putting" Away Bond Risk: An Empirical Examination of the Value of the Put Option on Bonds

There is an extensive literature dealing with the effect of call provisions on corporate bond yields [5, 6, 7, 9, 11, 12, 16, 17] and municipal bond yields [3, 4, 13, 14, 18]. Because the call provision enables borrowers to refinance bonds during periods of low interest rates and exposes the lender to a call risk, callable bonds typically provide higher yields than similar noncallable bonds. Other studies have examined the level of this call premium over the interest rate cycle [1, 2, 11, 12]. This protection against unfavorable interest rate movements has traditionally been available only to the borrower. Lenders historically have not been protected by the inclusion of floating rate provisions or provisions in a bond. A put bond permits the lender to (or sell) the bond back to the borrower, at par, under certain conditions. This paper examines a relatively new financial instrument: the put or option tender bond.