By Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
Owning bonds with call features is common for investors with a fixed income allocation consisting of individual bonds. As with any feature of securities you own, it is important to understand how those features work and how they could affect you and your investment portfolio. In today’s commentary, I will provide a refresher course on traditional call options and how to think about them in your fixed income portfolio.
If a bond has a traditional call option, it means that the issuer has the option to redeem (or “call”) the bond prior to its stated maturity at a pre-determined date and price. For example, if a bond matures in 10 years but is callable in five years at par, the issuer will have the option to redeem the bond in five years at par. Typically, an issuer will choose to exercise the call option when they are able to issue new debt at a lower rate than the outstanding bonds. This could be due to a range of factors, but usually an issuer will be able to issue debt at a lower rate either because the their overall credit quality has improved or because general yield levels are lower than they were when the debt was originally issued. Think of it as refinancing a mortgage: if you are currently paying a 7% rate on your mortgage and you can refinance today at 3%, you will likely take advantage of that option because it will save you money. The same logic applies to a corporate or municipal issuer, if they can reduce their interest expenses by calling in bonds and reissuing at a lower rate, they are likely to do so.
So how should you think about call options when it comes to owning a portfolio of bonds? It all comes down to understanding the risk/reward tradeoff that comes along with calls. Oftentimes, a bond with a call option will offer an investor more yield than an identical bond without the call option. You are earning additional yield for taking on the risks that come along with owning a callable bond.
For example, consider two 10-year bonds priced at par with one of them being non-callable and the other being callable in two years. If the callable bond is yielding 4.25% and the non-callable bond is yielding 4.00%, as an investor you have to weigh the risk/reward based on your own personal situation as to whether you want to purchase the non-callable bond and know for certain (barring a default) that you are going to earn 4% for the next 10 years, or if you want purchase to the callable bond that offers a higher yield with the understanding that the bond might be redeemed two years from now. The risk in the callable bond is that yields are lower two years from now and the issuer calls the bond, meaning that you now have money to reinvest in a lower yielding environment. So you might earn 4.25% for two years, but then (hypothetically) have to reinvest into a bond yielding 2.50%. Compare this to the non-callable bond, where you could earn 4.00% over the next 10 years, regardless of what interest rates do. Neither bond is “better” than the other, but there is a give-and-take that comes along with the differing features. Some investors might purchase the callable bond hoping that interest rates fall and the bond gets called, because their investment timeline is only two years and by purchasing the callable 10-year bond, they are able to earn a better yield than if they were to simply purchase a 2-year bond. The risk in this strategy is that interest rates rise, and while they had hoped the bond would be redeemed in two years, it will likely remain outstanding for a period longer than the two years they had hoped for (this is known as extension risk).
This is a simplistic example, but shines some light on the different ways to view a callable bond. Beyond a basic decision like the one outlined above, there are other ways to “use” callable bonds in your portfolio, which depending on your individual situation may or may not apply. A few common strategies are briefly summarized below.
The current interest rate environment is offering very attractive yields relative to recent history, which is creating many strategic options for investors. As described above, it may be possible to improve earnings or risk profiles through favorably structuring call features. Contact your financial advisor to discuss these options.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.
To learn more about the risks and rewards of investing in fixed income, access the Securities Industry and Financial Markets Association’s Project Invested website and Investor Guides at www.projectinvested.com/category/investor-guides, FINRA’s Investor section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.