What are callable bonds? And what are the risk and return of callable bonds?

Q: What are callable bonds? And what are the risk and return of callable bonds?

A: Callable bonds are fixed income securities that give the issuer the right, but not the obligation, to call in, or prepay, the bond prior to maturity. Issuers can be expected to exercise this right if they are able to reissue new debt at lower interest rates, once all costs of a recall and new issuance are considered.

The presence of the call feature greatly affects the risks and potential rewards of owning a bond. The failure to understand this risk creates the potential for large losses and investors being abused by broker-dealers. Most municipal and agency bonds, as well as some corporate bonds, have a feature that gives the issuer the right, but not the obligation, to prepay the principal (prior to maturity) on a specific date or dates. This call feature creates significant risk to investors, for which they do receive a higher yield as compensation. The higher yield creates the potential for great returns but also, depending on the price paid for the bond, the potential for underperformance because the issuer will only call the bond if interest rates have fallen significantly since the time of issuance (rates need to have fallen sufficiently to overcome the cost of a new issue to replace the original one).

When an investor purchases a bond with a call feature, the incremental yield slightly shortens the bond’s duration. As a result, if rates rise, the value of the callable bond will not fall quite as much. But in accepting this benefit, the investor is also accepting the risk that, should interest rates fall significantly, the bond likely will be called by the issuer (assuming the issuer has maintained its credit worthiness). Because of the higher incremental yield, many broker-dealers tend to build portfolios with longer-maturity bonds that contain short call features. Longer-term bonds typically have higher markups, so this strategy allows brokers to charge higher markups in the hope that the bonds will get called, giving them the opportunity to mark up another bond. This strategy can have negative consequences to investor when interest rates rise because the duration of the portfolio could rise dramatically, adding more volatility. The same is true if rates fall because this is when bonds will typically be called, leaving the client to invest in a low-interest-rate environment.

Bottom line: When analyzing whether a callable bond is an appropriate investment, the investor should consider whether the higher yield is sufficient compensation for the risk that falling rates will lead to early redemption of the bond. It’s also important to keep in mind that the call feature is there to benefit the issuer and not the investor.

We prefer to build ladders with either non-callable bonds or bonds with at least 80 percent call protection. This approach provides more “control” over when the funds come due as well as the duration, allowing the ladder to stay intact.

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