Why is this statement incorrect?

CFA Level III
#1

Why is this statement incorrect?

"Put structures will provide investors with some protection in the event that interest rates rise sharply but not if the issuer has an unexpected credit event.”

Puttable bonds allow investor to put the bond and re invest in higher interest rate securities…but if a credit even happens Issuer may not be able to meet the put feature of the bond…so how is the statement incorrect?

Thanks

#2

Because in the event of default of issuer, put option may not help since issuer wouldn’t make repurchase. Better protection from credit event are CDS, binary credit options and credit spread options and forwards.

#3

“But not if the issuer has an unexpected credit event”

A credit event could mean an issuer downgrade. This would increase the yield on the bond & decrease price meaning it may be attractive to put back to the issuer (some protection)

I believe you are thinking of it as a default of issuer, in which case it would not protect.

#4

N.Van is asking why is the statement incorrect i.e. put WILL protect if issuer has a credit event

#5

there are put options that protect investors from credit event.

#6

The issue of put is the option put writter. Incase interest rate rise, value of bond drops, the option holder may wishes to exercise his put option. If the writer has sudden credit event, that makes him unable to honor his obligation, then the opiton holder will suffer the loss in value link this to credit risk in options

#7

I mentioned binary options.

#8

Thanks Flashback, that is what I was thinking “the binary options” :slight_smile:

#9

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=972137

“We fi…nd that the dominant source of spread reduction is attributable to default risk - an average of 60% of the reduction. But, we …find that when default is imminent and the fi…rm may not be able to honor the option, the put option value is signifi…cantly reduced.”

I would say that for AAA-BB the put has increasing value, beyond BBB the put loses value…

#10

Guys, you are not answering his question! Why is the statement INCORRECT?

I also don’t get it and would appreciate if someone could explain. Thanks!

#11

I believe it’s because if you put the bonds back to the company when it has a credit event (lets say bankruptcy for example). You are unlikely to get those bonds paid out at face value, since the issuer (the company) will likely not fulfill its obligations. Therefore your put might as well be worthless.

#12

It’s incorrect because put options WILL provide investors some protection in the event of an unexpected credit event. They can call their loan. The question doesn’t specify that the company is in default and can’t honor their put. For all you know, it could just be a simple downgrade from AA to A.

#13

Hahaha that’s right, my brain is totally fried right now. That double negative made me go full derp…

#14

That makes sense, thanks much!

#15

Howling gives an easier to understand example. but i’ll break this down a bit more…

credit event aaa±>aa the credit spread widens, but the put value increases, so bond performs better than plain aa.

credit event bbb->b put loses value, issuer unlikely to honor the put.