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With bonds, be wary of call risk

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POSTED: December 13, 2007 5:00 a.m.

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 strategies 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 set forth 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.

Evans is a financial advisor with Edward Jones in Richmond Hill.

 

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