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What are callable bonds

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

Category: Bank

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