What it is:
How it works (Example):
Example #1: Bob dies in year 2, and interest rates are now at 3%. Because the price of a bond goes up when interest rates go down, Bob's estate can sell the bond on the open market for more than $1,000. The estate benefits from the decline in interest rates, just like if the bond did not have a death put.
Example #2: Bob dies in year 2, but interest rates have spiked to 8%. The bond now trades at well below par value, but Bob's estate can exercise the death put option and sell the bond back to the issuer for $1,000. Bob's estate doesn't lose money on an increase in interest rates because of the death put feature.
Why it Matters:
A bond with an embedded put option increases the value of the underlying bond because it creates a floor on the price (though in this case the floor is contingent on a very specialized occurance). An issuer might offer a death put in order to make the bonds more attractive to certain investors.
But because the bond is so specialized, it may be difficult to find buyers in the secondary market if the bondholder is still alive but wants to sell. Any time you invest in a highly-specialized asset, you can expect the secondary market to be more challenging than if you purchased a standardized asset.