Beware of ‘call risk’

The Covington News - - BUSINESS -

When you buy a bond, it’s yours un­til you sell it or it ma­tures, right? Not al­ways.

Some­times, the bond is­suer can buy it back early. If that hap­pens, your in­vest­ment plans can change — so you’ll want to be pre­pared to take ac­tion.

Why would a bond is­suer buy back, or “call,” a bond? The an­swer is pretty straight­for­ward: to save money. When mar­ket in­ter­est rates drop, the is­suer, such as a cor­po­ra­tion, or state or lo­cal gov­ern­ment (vir­tu­ally all U.S. Trea­sury bonds are not callable) may de­cide to call its bonds, pay off bond­hold­ers like you, then reis­sue new bonds at the lower rates, thereby sav­ing money on in­ter­est pay­ments — and de­priv­ing you of a high-yield­ing as­set.

At first glance, this sce­nario may not look par­tic­u­larly fa­vor­able, but you’re not quite as vul­ner­a­ble as you might think. First, “callable” bonds, be­cause they con­tain the risk of be­ing cashed in early, may of­fer a higher in­ter­est rate than com­pa­ra­ble, but non-callable, bonds. Also, some is­suers may pay you a “call pre­mium” — such as one year’s worth of in­ter­est — when they call your bond.

How can you know if a bond can be called? Be­fore you buy a bond, check its spe­cific terms, which are con­tained in its in­den­ture — the writ­ten agree­ment be­tween the bond is­suer and the bond­hold­ers. Th­ese terms in­clude the bond’s in­ter­est rate, ma­tu­rity rate and other terms — such as call pro­vi­sions. Some bonds are “freely callable,” which means they can be re­deemed any­time.

How­ever, you can avoid un­pleas­ant sur­prises by buy­ing a bond that can­not be called — that is, a bond that of­fers “call pro­tec­tion” — for a given pe­riod of time. For ex­am­ple, if you buy a bond whose first call is three years from now, you’ll be able to take ad­van­tage of your bond’s in­ter­est rate for at least three years, re­gard­less of mar­ket rate move­ments. (Some bonds, called “bul­let bonds,” can­not be called at all. Bul­let bonds, like other bonds with call pro­tec­tion, are typ­i­cally more ex­pen­sive — i.e., they pay lower in­ter­est rates — than callable bonds.)

None­the­less, you may not al­ways be able to find the bonds you want with call pro­tec­tion. And if you own a bond that is cur­rently callable and pays more than newer bonds of iden­ti­cal qual­ity, you may well get a call in the near fu­ture. You should be pre­pared for bond calls well be­fore they oc­cur. To help pro­tect your port­fo­lio from call risk, you may want to cre­ate a “bond lad­der.” To build a bond lad­der, you buy bonds with vary­ing ma­tu­rity and call dates. Then, if some of your bonds are called, you’ll still have other bonds with many years left un­til ma­tu­rity; some of th­ese bonds may still en­joy call pro­tec­tion. So, while some of your bonds may still be at risk of be­ing called, your bond lad­der can help pro­vide you with some over­all port­fo­lio sta­bil­ity.

You can’t pre­vent a bond call — but if you know it may be com­ing, you can at least be poised to take pos­i­tive ac­tion.

Joe Stier

In­vest­ment Rep­re­sen­ta­tive

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