Callable Fixed Income Securities

“There is no free lunch!” – How many times have you heard this line? Well, it is true. Generally, the higher the risk, the higher the reward. Similar logic may be applied to fixed income investing. In order to earn a potentially higher return, an investor may have to accept a certain amount of risk – the exact amount of which depends on various factors. Lower-quality bonds usually offer higher yields to compensate investors for the possibility that an issuer may default on its obligation to pay interest or return principal. Long-term bonds may also offer higher returns to compensate investors for a longer capital commitment, as well as the risk of missed reinvestment opportunities should interest rates rise. Additionally, relatively higher yields may be earned by investing in callable bonds.

With callable bonds, investors are taking a chance that an issuer may redeem (call) them prior to the stated maturity date. If the bonds are called, which generally happens when interest rates decline, investors may have to accept lower income payments as bond proceeds are reinvested at lower coupon rates. To compensate investors for the reinvestment risk and unknown final term of investment, callable bonds generally offer higher yields than non-callable alternatives. Investors in callable bonds must consider two yields — the yield-to-call (YTC) and the yield-to-maturity (YTM) — when analyzing the return scenarios of callable bonds. If both yields are acceptable, then callable bonds may present a suitable investment for those seeking potentially higher returns.

Callable securities, issued by U.S. government entities, corporations and financial institutions, generally offer a stated final maturity but allow the issuers, at their option, to redeem (or call) the bonds prior to term after an initial non-call period. A call schedule is determined at the time of issuance. Bonds may be called on specific dates only, or at any time after the non-call period. Most bonds are callable at face value plus accrued interest. Additionally, some securities may be callable at any time based on special call provisions.

Investment Considerations

Callable bonds may not be suitable for investors interested in steady income and predictable returns. The bonds may be called prior to maturity and, thus, the term of the investment may be shorter than expected. The option to call the bonds belongs to the issuer and not the investor. Calls usually occur when market interest rates decline. Generally, the issuer may call the bonds if it can sell new ones with lower coupon rates and reduce the cost of capital.

In some circumstances, a call may occur when the time to maturity has diminished to a point on a yield curve where rates are lower. For example, if a bond is scheduled to mature in two years and interest rates on new-issue two-year bonds are lower than what the old bond is paying, it may be more cost-effective for the issuer to call the existing bonds and replace them with a new offering at a lower yield. If the bonds are called prior to maturity, the interest payments will stop and investors may have to reinvest proceeds at lower yields.

The amount of extra yield and the call protection period should be commensurate with investors’ financial objectives. Since calls are not mandatory and may not be forecasted with 100% certainty, investors should analyze multiple scenarios when considering callable bonds for their investment portfolios. In addition to the YTM – the yield an investor will receive if bonds are held to maturity – a yield-to-worst (YTW) scenario should be taken in to account before making the final decision. A YTW is the lower of either the YTM or the YTC.

When interest rates decline, market values of callable bonds are not likely to rise as much as their non-callable alternatives. Since the possibility of a call increases, lesser demand from investors keeps the callable bond prices from rising. Therefore, it is especially important to consider the yield-to-worst when purchasing bonds at a premium as bonds may be called at par.

Interest Rate Effects on Callable Securities

Direction of Interest Rates Effect on Callable Securities

Increasing

  • Bonds may not be called. Investors should expect to hold bonds until maturity.
  • Yield-To-Maturity is usually comparable or higher than that of non-callable bonds as a means of compensation for the potential of eventual call.
  • Investors, who need access to funds prior to the final maturity, may sell bonds in the secondary market at a prevailing price, which may be less than the original purchase price.
  • Higher coupon callable bonds may be less sensitive to rising interest rates and, hence, provide potential for smaller price depreciation as the higher coupon acts as a cushion.


Decreasing

  • Bonds may be called and investors face the loss of current income.
  • Yield-To-Call (return) is usually higher than the return originally offered on comparable shorter-term non-callable bonds.
  • Investors face reinvestment risk as most calls occur in a lower interest rate environment.
  • A high coupon bond, offered at a premium, is called a “kicker” and sold based on the yield-to-worst basis. But if the bond is not called on the scheduled date, the yield to the investor “kicks up.”
Types of Call Options

American Call. Issuer has the right to call a bond at any time starting on the first date the bond is callable until its maturity – known as “continuously callable.”

European Call. Issuer has the right to call a bond only once on a predetermined date, starting on the first date the bond is callable – known as a “one time only” call.

Bermuda Call. Issuer has the right to call a bond on interest payment dates only, starting on the first date the bond is callable.

Canary Call. A step-up bond becomes non-callable after the first step has been reached. Similar to Bermuda call, bonds may only be called on specific dates. If bonds are not called before the first step-up in coupon occurs, they become standard non-callable step-up bonds until maturity.

Make-Whole Call. This call option is used increasingly in new issue bonds and meant to compensate investors with a premium price should the call occur. The premium price is generally expressed as certain number of basis points (spread) over the yield on a comparable Treasury security (T). For example: T+100 bp. One basis point is 0.01%. Let’s assume that a 4.75% coupon bond is trading at par, or $1,000 per bond. This means that its yield is equal to 330 bp spread over a 3-year Treasury note, which is yielding 1.45% (475 bp – 145 bps = 330 bp). In this example, the issuer may only call the bonds at a yield equal to T+15 bp. The call price would be $1,093 per bond. With a Make Whole Call option, the call price is based on the Treasury yield at the time the call occurs, and, therefore, cannot be predicted. The call price is the greater of par or the price calculated using the make-whole-call premium.

Tax Law Changes Call. Issuer has the right to call a bond when tax laws change in a way that has an adverse impact on the issuer.

Other Calls. Special par calls may exist for eminent domain actions and sale of assets (typically for utilities); equity claw-back calls usually exist for high yield bonds; extraordinary calls due to drops in receivables generally apply to retail issuers. Investors should read a prospectus to verify call details before investing.

Sinking Fund Redemption

A sinking fund provision allows the issuer to redeem bonds, in part or whole, prior to maturity using excess revenues that the issuer periodically deposits in to a fund trust. The sinking fund call schedule and the call price are set at the time of issuance. Some bonds may be called at par or the prevailing market price, whichever is less. In the case of a Mandatory Sinking Fund, the bonds must be called before the stated maturity date.

Pre-Refunded Bonds

This feature is common to municipal bonds. When an issuer plans to call bonds prior to maturity, it can issue new bonds at lower rates and/or longer maturities and use the proceeds to redeem previously-issued callable bonds. Generally, an issuer will offer pre-refunding bonds in advance and invest the proceeds in Treasury bills until the scheduled call date. The call schedule and price is set at the time of the issuance of the original bonds. The call price may be at or above par. As with other call options, the issuer may call bonds when interest rates drop in order to refinance older issues at lower rates. For more information about pre-refunded bonds visit the Municipal Securities Rulemaking Board at emma.msrb.org.

Investors should examine each bond’s features to properly assess the risk/reward ratio. Utilized carefully, callable bonds may potentially help increase the total return of a well-diversified portfolio. For more information about callable securities, visit the Financial Industry Regulatory Authority at finra.org, U.S. Securities and Exchange Commission at sec.gov and SIFMA’s investinginbonds.com.

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