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Knock, knock, who’s there?
Knock, knock! Who’s there? It’s your bond calling at your door to return your principal sooner than the maturity.
Normally, a bond is a very simple investment instrument. It pays interest until expiration and has a single, fixed lifespan. The callable bond, on the other hand, is the exciting, slightly dangerous cousin of the regular bond.
Recall that a bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments, corporations and municipalities issue bonds when they need capital. Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as maturity.
If an investor buys a corporate bond, the investor is lending the corporation money. The corporation, now referred to as the bond issuer, determines an annual interest rate, known as the coupon, and a time frame within which it will repay the principal. To set the coupon, the issuer will typically take into account the prevailing interest rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors.
As a result, new issues of bonds and other fixed-income instruments will typically pay a rate of interest that mirrors the current interest rate environment. If rates are low, then the bonds issued during that period will likely pay a low rate as well. When rates are high, the same rule applies.
A callable bond (also called a redeemable bond) is a type of bond that allows the issuer of the bond to retain the option of redeeming the bond at some point before the bond reaches its date of maturity. As a result, callable bonds have two potential life spans, one ending at the original maturity date and the other at the "call date."
Why would an issuer want to redeem a bond early?
If interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at a lower rate of interest, as it can be a drain on their cash flow if they are required to continue paying a high interest rate. Therefore, issuers often include a “call feature” as part of the terms of their bond.
For example, a corporation that issues a 20-year note paying 8% 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 8% to its bondholders if interest rates have dropped to, for example, 4% after the bond was issued.
Types of Call Features
Optional redemption lets an issuer redeem its bonds when it chooses but usually after a set time period, for example 10 years. Sinking fund redemption requires the issuer to adhere to a set schedule while redeeming a set portion or all of its bonds. Extraordinary redemption lets the issuer call its bonds before maturity if specific events occur.
Bondholders will receive a notice from the issuer informing them of the call, followed by the return of their principal.
Investors who own bonds which are called are left with the dilemma of what to do with their money after their principal is refunded. Of course, they could leave their funds in cash, but most will seek to replace their called bond with a similar investment, if possible. However, attractive replacements are unlikely to be readily available because these bonds are called when rates are low. Since call features are considered a disadvantage to the investor, callable bonds, especially ones with longer maturities, usually pay a slightly better rate than comparable non-callable issues.
Look before you leap
As is the case with any investment instrument, callable bonds have a place within a diversified portfolio. However, investors must keep in mind their unique qualities and form appropriate expectations since a callable bond can be called away if interest rates fall. Should this happen, you would have benefited in the short term from a higher interest rate, but would then be forced to reinvest your assets at the lower prevailing rates.
Toni-Ann Neita is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org
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