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CALLABLE BONDS  

During the early 1980s, inflation was running rampant and appeared destined to be with us for a long time.  The prime rate was fast approaching 20%.  Consumer confidence was weak.  Yet, through all of this, corporations were faced with debts that needed to be rolled over and new plants and equipment that needed to be financed.  The same situation faced government units.  In order to complete financing needs many shorter-term obligations were issued.  Longer bonds that were issued, however, often came with a callable feature attached.  Thus, these bonds are known as Callable Bonds.  

As borrowing costs decrease, those corporations and government units mentioned above are now calling their high coupon bonds for early redemption.  

Callable Bonds represent bonds that entitle the issuing firm or government unit to retire the whole bond issue, or any part of it, before its original maturity date, possibly at a small premium to par.  This premium usually starts at one year’s interest during the first year of call and then declines each year after that toward zero.  This call feature is a major benefit to the issuing party because it entitles them to the opportunity to call in high-interest bonds and replace them with lower-interest bonds, if the rates decrease, reducing their interest expenses.  

The loser in a callable bond transaction is the investor who owns the bond.  The investor loses in two different ways.  

First, if the bond is called, the investor will not receive the income originally expected over the life of the instrument.  The reason for this is that if a bond is called, then interest rates have come down significantly since the bond was originally issued. When the proceeds from the called bond are received, the investor will no longer be able to reinvest the money in a new bond that pays as high an interest rate as previously received.  Thus, the interest income becomes less than expected.  

Let us look at an example:  Today an investor buys a $100,000 tax-exempt bond with a 10% coupon.  The bond matures in 20 years for $100,000.  Therefore, the investor expects to receive $10,000 of income for each of the next 20 years.  

1. The maturity value of the bond is still $100,000.
2.  If you had reinvested the income at 10%, the 20 payments of $10,000 each would have accumulated $630,025.
3. Your total value would then be $730,025.

However, suppose that 10 years later interest rates have dropped dramatically and the $100,000 bond is called by the issuer.  The investor is now forced to reinvest the proceeds in a new 10-year bond, but the new interest rate is only 6%.  

Thus, for the last 10 of the original 20 years, the investor will receive only $6,000 of income instead of the $10,000 he or she originally expected.  Let us see how that affects the end result:  

If the bond, however, were not called and using the same reinvestment rates, the total accumulation would have been much greater.  Thus, the bond being called cost the investor $232,248!  

The second way an investor will lose if a bond is callable, is that the market price will not move much above the par value plus the call premium.  No one else will want to pay over this amount and be subject to an immediate principal loss should the bond be called.  Thus, if one ever wants to sell the bond, its true economic worth may not be realized because of this call provision.  

When purchasing a bond, be aware of possible call provisions.  Remember, that these provisions are for the benefit of the issuer, not the investor.  Unless you receive a higher interest rate for taking this risk when buying the bond, avoid it.

Securities offered through Sigma Financial Corporation. A registered broker/dealer. Member FINRA & SIPC.

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Last modified: 11/04/07