Callable Fixed Income Securities
A call option provides the issuer with the benefit of redeeming a bond prior to its maturity. Bonds are generally called when interest rates decline; therefore investors remaining in the market must reinvest in lower yields. As such, an investor typically demands a little more yield on a callable bond over a comparable bullet, (non-callable), structure to compensate for the call risk. 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.
Call schedules are determined at the time of issuance and vary. Calls may be one time only, on specific dates or continuous. Most bonds are callable at face value plus accrued interest. Additionally, some securities may be callable at any time based on special call provisions.
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 call risk and yield compensation should be commensurate with investors' financial objectives. Calls are not mandatory and therefore an option that may or may not be executed. The yield-to-maturity (YTM) as well as the yield-to-worst (YTW) should be taken in to account before making the final decision.
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. Callable by a predetermined call schedule up to a period of time, then either called or converted to a bullet structure moving forward.
Make-Whole Call. A call that when exercised by the issuer, provides an investor with a redemption price that is the greater of the following:
1. Par value, or
2. A price that corresponds to the specific yield spread over a stated benchmark such as a comparable Treasury security (plus accrued interest)
A make-whole call provides a form of protection, as implied by the name, because it requires the investor to at least, “be made whole” (par value) and can be viewed as a form of downside protection.
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 into 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.
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 and invest the proceeds in Treasury bills until the scheduled call date.
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.