Yahoo Finance What Investors Should Know About Callable Bonds
Bond investors are used to studying features like yield, maturity and credit quality. But many municipal and corporate bonds throw a curve: a "call" feature that ends the income flow, adding a layer of risk that can upend the investor's calculations.
With bond yields at record lows, is a call feature a red flag or an added attraction?
"I am a fan of callable bonds as an investment strategy, especially within municipal bonds," says Scott Stratton, president of Good Life Wealth Management in Dallas.
Stratton praises callable bonds for offering investors some protection from rising rates. Others aren't so sure, suggesting that prices on good callable bonds are already too high.
"If you purchase a callable bond above the price it can be called at, you stand to lose money if it is called" early enough, says Matt Hylland of Hylland Capital Management in Virginia.
[See: 10 Great Ways to Buy Emerging Markets.]
A bond that may be paid early. Like all bonds, callable bonds are loans from the investor to the issuer. After receiving interest payments for a specified period of months to decades, the investor is repaid the principal, or face amount of the bond.
With a callable bond, the issuer can opt to pay the principal early, typically after a given period such as 10 years on a 30-year bond. Companies and municipalities are most likely to redeem bonds after interest rates fall, paying off older high-rate bonds by selling new ones with lower yields -- just as a homeowner would refinance a mortgage.
That's great for the issuer, but it deprives the bond owner of the expected income stream, and typically forces the investor to reinvest in bonds with lower yields, reducing future interest income.
On the other hand, this additional risk is often compensated to some degree by a higher yield, or coupon, than on a comparable non-callable bond. After all, greater risk demands a greater reward.
Change the focus. For safety's sake, many experts say investors should focus not on a bond's yield to maturity but on its yield to call, a usually lower figure calculated from the price and yield over the shorter period. Many online bond calculators provide for this.
But price variations add another twist because the bond, like non-callable bonds, may sell for a premium or a discount to face value. The call feature affects the price. An inattentive investor who pays a premium for a bond to get a higher yield can be disappointed when the bond is called and the principal received -- the "par," or face value -- is less than was paid.
When rates on new bonds rise, older bonds that pay less sell for discounts, since investors prefer the new bonds' more generous yields. When rates fall, the opposite occurs and older more generous bonds sell for more.
Rising and falling rates have an especially strong effect on bonds with long maturities, since their owners will be stuck with below-market yields, or enjoy above-market yields, for so long. On a long-term bond, a 1 percentage-point change in prevailing rates can drive the price up or down by 10 percent.
[See: 7 Global Goats That Could Bring Market Mayhem.]
A call feature basically shortens the bond's expected maturity, making changes in interest rates less meaningful to the bond price. As a result, Stratton says, callable bonds have smaller premiums when rates are low, making them a better buy today. The yield is thus higher relative to the price, and the investor is less likely to lose money if the bond is called.
"Where a non-callable bond may be priced at 110 (percent of face amount) or higher, callable bonds will be priced lower, based on their call date," he says. "If a bond is currently callable, it should trade very close to par."
With interest rates at record lows today, there's a better chance they will rise than fall, making callable bonds a good bet because calls are less likely, Stratton says.
Then again, "if you expect interest rates to fall, you would actually be better off buying non-callable bonds so you can enjoy greater price gains," he says.
Short supply. But if you find callable bonds more interesting, there's just one problem: There aren't many around anymore.
"The biggest problem with callable bonds is that they have mostly been called by now!" Stratton says. "Today it is basically impossible to find any 5 percent coupon munis that are callable, and 4 percent are becoming rare. I used to be able to find high quality bonds with nice coupons trading close to par, but have not seen any in years."
As with any investment, it's important to look at terms that may be unique to each bond, such as the first possible call date and the call price, which may not be the face amount. Some bonds can be called only when certain conditions arise, some can be called only on a given date but not later, others any time after the call date arrives. In some cases yield can change at certain intervals.
Hylland recommends looking for the bond's lowest yield figure. That's yield to call rather than yield to maturity if the bond sells for a premium, because the earlier call date causes the premium to chew more deeply into overall earnings. Of course, it's also important to look at the bond's credit rating, to gauge the default risk.
While sophisticated investors and those relying on experts buy individual bonds, many small investors use mutual funds, allowing professional managers to find the best deals. Many bond funds, especially those specializing in municipal bonds, include callable issues.
[Read: Prospects for an Aging Bull Market.]
"Given the large number of issuers and premium attached to purchasing small lots, many investors have found it beneficial to invest through a mutual fund," says Chad Farrington, head of municipal bond credit research at Columbia Threadneedle Investments in Boston, referring to the quantity discounts available to pros.
More From US News & World Report
