Understanding Callable Bonds: How Early Redemption Impacts Investors

Fixed income securities such as bonds can come with call features that give their issuers the right to call them, or refund the principal at a future date but prior to maturity. This offers the issuers protection from a drop in interest rates but it also forces investors to reinvest their money at less attractive rates.

Callable bonds often pay a higher coupon rate (i.e. interest rate) than noncallable bonds to attract buyers despite their call features. Various types of fixed income securities can be called, including corporate bonds, municipal bonds, CDs, and preferred stock. If a bond is going to be called, bond issuers will send a notice of call to the bondholder and then return the principal. Investors can use bond strategies, such as laddering, to help reduce call risk.

Understanding Call Features in Bonds

New issues of bonds and other fixed-income instruments will pay a rate of interest that mirrors the current interest rate environment. If rates are low, then all the bonds and CDs issued during that period will pay a low rate as well. When rates are high, the same rule applies. However, issuers of fixed-income investments have learned that it can be a drain on their cash flow when they are required to continue paying a high-interest rate after rates have gone back down. Therefore, they often include a call feature in their issues that provides them a means of refunding a long-term issue early if rates decline sharply. Many short-term issues are callable as well.

For example, a corporation that issues a 30-year note paying 5% may incorporate a call feature into the bond that allows the corporation to redeem it after a predetermined period of time, such as after five years. This way, the corporation won't have to keep paying five percent to its bondholders if interest rates drop to 2% to 4% after the issue is sold. Corporations will also sometimes use the proceeds from a stock offering to retire bond debt.

What to Expect When Your Bond Is Called

Bondholders will receive a notice from the issuer informing them of the call, followed by the return of their principal. In some cases, issuers soften the loss of income from the call by calling the issue at a premium, such as $105. This would mean that all bondholders would receive a 5% premium above par ($1,000 per bond) in addition to the principal, as a consolation for the call.

Since call features are considered a disadvantage to the investor, callable bonds with longer maturities usually pay a rate at least a quarter-point higher than comparable non-callable issues. Call features can be found in corporate, municipal and government issues as well as CDs. Preferred stocks can also contain call provisions.

Potential Financial Risks of Callable Bonds

Let's look at an example to see how a call provision can cause a loss. Say you are considering a 20-year bond, with a $1,000 face value, which was issued seven years ago and has a 10% coupon rate with a call provision in the tenth year. At the same time, because of dropping interest rates, a bond of similar quality that is just coming on the market may pay only 5% a year. You decide to buy the higher-yielding bond at a $1,200 purchase price (the premium is a result of the higher yield). This results in an 8.33% annual yield ($100/$1,200).

Suppose that three years go by, and you're happily collecting the higher interest rate. Then, the borrower decides to retire the bond. If the call premium is one year's interest, 10%, you'll get a check for the bond's face amount ($1,000) plus the premium ($100). In relation to the purchase price of $1,200, you will have lost $100 in the transaction of buying and selling. Plus, once the bond is called, your loss is locked in.

Considerations When Buying Callable Bonds

When you are buying a bond on the secondary market, it's important to understand any call features, which your broker is required to disclose in writing when transacting a bond. Usually call provisions can be inspected in the issue's indenture.

When analyzing callable bonds, one bond isn't necessarily more or less likely to be called than another of similar quality. You would be misinformed to think only corporate bonds can be called. Municipal bonds can be called too. The main factor that causes an issuer to call its bonds is interest rates. One feature, however, that you want to look for in a callable bond is call protection. This means there's a period during which the bond cannot be called, allowing you to enjoy the coupons regardless of interest rate movements.

Before buying a callable bond, it's also important to make sure that it, in fact, offers a higher potential yield. Find bonds that are non-callable and compare their yields to callable ones. However, locating bonds without call features might not be easy, as the vast majority tend to be callable.

If you own a callable bond, remain aware of its status so that, if it gets called, you can immediately decide how to invest the proceeds. To find out if your bond has been called, you will need the issuer's name or the bond's CUSIP number. Then you can check with your broker or a number of online publishers.

Finally, don't get confused by the term "escrow to maturity." This is not a guarantee that the bond will not be redeemed early. This term simply means that a sufficient amount of funds, usually in the form of direct U.S. government obligations, to pay the bond's principal and interest through the maturity date is held in escrow. Any existing features for calling in bonds prior to maturity may still apply.

Strategies to Prepare for Bond Calls

As we mentioned above, the main reason a bond is called is a drop in interest rates. At such a time, issuers evaluate their outstanding loans, including bonds, and consider ways to cut costs. If they feel it is advantageous for them to retire their current bonds and secure a lower rate by issuing new bonds, they may go ahead and call their bonds. If your callable bond pays at least 1% more than newer issues of identical quality, it is likely a call could be forthcoming in the near future.

At such a time, you as a bondholder should examine your portfolio to prepare for the possibility of losing that high-yielding asset. First look at your bond's trading price. Is it considerably more than you paid for it? If so, it may be best to sell it before it is called. Even though you pay the capital-gains tax, you still make a profit.

Of course, you can prepare for a call only before it happens. Some bonds are freely-callable, meaning they can be redeemed anytime. But if your bond has call protection, check the starting date in which the issuer can call the bond. Once that date passes, the bond is not only at risk of being called at any time, but its premium may start to decrease. You can find this information in the bond's indenture. Most likely a schedule will state the bond's potential call dates and its call premium.

Finally, you can employ certain bond strategies to help protect your portfolio from call risk. Laddering, for example, is the practice of buying bonds with different maturity dates. If you have a laddered portfolio and some of your bonds are called, your other bonds with many years left until maturity may still be new enough to be under call protection. And your bonds nearer maturity won't be called, because the costs of calling the issue wouldn't be worth it for the company. While only some bonds are at risk of being called, your overall portfolio remains stable.

The Bottom Line

There is no way to prevent a call. But with some planning, you can ease the pain before it happens to your bond. Make sure you understand the call features of a bond before you buy it, and look for bonds with call protection. This could give you some time to evaluate your holding if interest rates experience a decline. Finally, to determine whether a callable bond actually offers you a higher yield, always compare it to the yields of similar bonds that are not callable.

Calls usually come at a very inconvenient time for investors. Those who get their principal handed back to them should think carefully and assess where interest rates are going before reinvesting. A rising rate environment will likely dictate a different strategy than a stagnant one.