Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the result of a rising interest rate for a putable bondholder?

1. The bondholder must hold the bond to maturity.

2. The bondholder can sell back the bond to the issuer.

3. The bondholder will receive a higher yield.

4. The bondholder loses the option to sell.

The correct answer is: The bondholder can sell back the bond to the issuer.

The correct answer highlights a crucial feature of putable bonds, which gives the bondholder the option to sell the bond back to the issuer at designated times before maturity. As interest rates rise, the value of existing bonds with lower coupon rates typically decreases, making new issues more attractive to investors due to their higher yields. In this context, the putable bondholder has a valuable option to respond to changing market conditions. When interest rates increase, the bondholder can exercise the put option and sell the bond back to the issuer, thereby potentially mitigating losses from the bond’s declining market value. This option acts as a form of insurance against the adverse price movements that rising interest rates can create. This ability to sell back the bond provides flexibility that is beneficial in a rising rate environment, enabling the bondholder to avoid capital losses or reinvest the proceeds into higher-yielding securities. Thus, the ability to sell back the bond to the issuer is particularly advantageous when faced with rising interest rates.