Understanding Callable Bonds

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With most mortgages and car loans, there is an option to pay off the loan early. For a borrower, there are some distinct advantages to doing so. For the lender, early payment is less advantageous, and this situation is also true for the bond market.

Hearing the Call

When you buy a bond, you lock up your money in exchange for a particular rate of return. You are essentially lending money to the seller. For example, if you buy a low risk, 15-year, AAA-rated corporate bond that pays a yearly amount, or coupon rate, of 4 percent, you expect to collect an annual return of 4 percent for the next 15 years in exchange for your investment.

In most cases, the corporation that sold the bond has agreed to pay you a coupon rate of 4 percent for the next 15 years. However, sometimes a bond seller reserves the right to “call” the bond early — paying off the principal and ending the loan before it matures. Such bonds are referred to as “callable.” They are fairly common in the corporate market and extremely common in the muni-bond market.

The Risks of a Callable Bond

Buying a callable bond may not appear any riskier than buying any other bond. But there are reasons to be cautious.

First, a callable bond exposes an investor to “reinvestment risk.” Issuers tend to call bonds when interest rates fall. That can be a disaster for an investor who achieved a level of safety by locking into a desirable interest rate.

If the Federal Reserve Bank cuts interest rates, the going rate for a 15-year, AAA-rated bond falls to 2 percent. The issuer of your bond may decide to pay off the old bonds issued at 4 percent and reissue them at 2 percent. As the investor, you will receive the original principal of the bond – $1,000 – but you will have difficulty reinvesting that principal and matching your original 4 percent return. You can either buy a lower-rated bond to obtain a 4 percent return or buy another AAA-rated bond and accept a 2 percent return.

Second, bond market insiders know that one of the most common mistakes that novice investors make is to buy a callable bond on the secondary or over-the-counter market as rates are falling and the “call date” – the day on which an issuer has the right to call back the bond – is approaching. In this situation, an investor may pay a principle of $1,000, a commission, and then promptly find that the bond is called. That investor will receive the $1,000, but the commission was paid for nothing.

Should You Buy a Callable Bond?

Buying any investment requires that you weigh the potential return against potential risk. For entry-level investors, callable bonds may be too complex to consider. For example, the prices of callable bonds in the secondary market move quite differently from the prices of other bonds. When interest rates fall, most bond prices rise, but callable bond prices actually fall when rates fall – a phenomenon called “price compression.” However, callable bonds offer some interesting features for the experienced investor.

Consider Interest Rates

If you are considering a callable bond, the biggest factor is interest rates. What do you expect to happen to interest rates between now and the call date? If you think rates will rise or hold steady, you do not have to worry about the bond being called. However, if you think rates may fall, you should be paid for the additional risk in a callable bond.

Therefore, shop around. Callable bonds pay a slightly higher interest rate to compensate for the additional risk. Some callable bonds also have a feature that will return a higher par value when called; that is, an investor may get back $1,050 rather than $1,000 if the bond is called. Make sure that the bond you buy offers enough reward to cover the additional risk.