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.
When interest rates rise and bond value goes down, I thought the put structure gives the holder value?
It does.
And if the issuer has an unexpected credit event, the bondholder can exercise the put even if interest rates aren’t particularly high. I believe that it’s the second part of the statement that’s incorrect, not the first.
You have bought the right to sell the bond back to the issuer at a better price. If the issuer has troubles regarding a credit event you’re screwed cause he wont be able to accomplish the deal.
Can you please explain why the second part is incorrect? A credit event may mean that the issuer is unable to buy the bond back, so the invstor doesn’t have protection.
It didn’t mention where on the rating chart did it happen. It would be a bigger risk for high yield junk bonds, than going from A2 to A3.
Its the typical counterparty risk associated with options. You got it too on the put bond… thats why in a credit event its worthless.
I agree that in a credit event the put option is worthless. So why then is the original 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.
Just because the issuer defaults doesn’t mean you won’t get back your money.
I guess it comes down to what is meant by “credit event”. Like MrSmart said, a downgrade in the top tiers of the IG sector should mean the issuer still has the ability to buy back the bond if the put is exercised. If credit event means an outright default, than i could see the issuer being unable to repurchase the debt. Still, we all learned a while ago that having an option embedded adds value for the option holder, so I would think even a puttable bond from a junk issuer would trade at a premium to a comparable bond with no option.
1: Not all credit events mean default.
2: Even if its a default, pecking order of payout could still result in putting the bond at face value.
I could be wrong though but at least thats what made sense to me.
That’s exactly right.
+1 , sometimes event may be a change in rating (or something else) which is not a default, sorry.
The point is that put options is in the money but herstatt risk; I think the original sentence is still not accurate because the mocks says so ; can s2k take a stab at this please?
Does a normal put option on a bond specify the particular credit events under which it becomes useless?