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Bond of the Week: Beware put options!

At first glance, the UK 5.5% 10th September 2012 Gilt looks to be a bargain for investors............

A quick glance at the UK Gilt yield curve shows a couple of bonds apparently yielding a little more than would be expected. This is due to an imbedded feature in the bond known as a “call”.  This feature gives the issuer, in this case the UK government, the option to redeem the bond early. An example of this is the UK Treasury 5.5% 10th September 2012, which can be redeemed early at the request of the Treasury*. The call is in September 2008, a short two years from now.
So does it matter if you get you money back early? Well, yes it does. When bonds are called by their issuers, they will be redeemed at par, or 100p in the pound plus any accrued interest owed. If the investor pays over par when he purchases the bond in the market, he will face an accelerated capital loss on his position, negatively impacting the overall return on the bond.
Let us take two scenarios for the UK Treasury 5.5% September 2012, assuming we purchase the bond at the current market price.
1)     We buy the bond at 100.60. Using a simple yield calculation, we will receive 100/100.6 times 5.5% ( the coupon) plus or minus the annualised capital gain/loss that is achieved between the purchase price and redemption. Thus, if the bond runs to its final maturity in September 2012, the yield will be:
  • 100/100.6 times 5.5% -(0.6% divided by 5.75 years) =  5.453%
2)     We buy the bond at 100.6 0. However, this time the bond is called in 2008, and not allowed to run its full life. In this scenario, we have to take our losses over a 21-month period, thus affecting the annualised return.
  • 100/100.6 times 5.5% - (0.6% divided by 1.75 years) =  5.12%
The prudent investor will always examine bonds for call features, and assume a “worst case scenario” when calculating the yield. This is the approach taken by the industry, which typically quotes a “yield to worst” when calculating the return on bonds with calls. On this basis, the UKT 5.5% September 2012 is still a fairly attractive proposition, but not quite as tempting as might first appear.
* Note, it is the issuer, not the the bondholder who has the option to "call" the bond.