Manage your bond's call risk

Key Points

• How Bond Call Options Work
• What to Look for on Callable Bonds
• Managing a Manageable Risk
• How to Manage Call Risk
• Call Risk Can Bring Opportunity
• Look Beyond the Call
• Points to Remember

When purchasing bonds, you may be most concerned with a bond's yield. What you should also consider is your bond's potential yield to the "first call."

Many investors purchase bonds, confident that the bonds can be held until maturity (the date when the bond must be turned in) and they can get their principal back with the promised interest. What they may not have checked, however, is whether the issuer can "call" the bond before maturity, forcing the investor to retire his or her bond at surprising interest rates and prices.

This "call risk" applies to many types of bonds — some more than others. Knowing what the risk is can save you from being caught off guard by a bond call, and also understand how much this risk should weigh in your overall investment decision.

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How Bond Call Options Work

An issuer may call some bonds before their maturity date. The first date on which a bond can be called is stated when it is issued. To protect investors who depend on bonds for long-term income, most call provisions state that a bond can't be called before a specified number of years, usually 5 or 10. Some bonds carry a series of call dates: A bond may be callable at a specific price after 5 years, and at another price if called in 10 years.

Investors tend to be compensated for call risk with slightly higher yields than those of noncallable issues. Many corporate and Ginnie Mae bonds are callable, as well as most municipal bonds. On the other hand, most U.S. Treasury bonds are not callable, and these issues — backed by the creditworthiness of the U.S. government — generally yield less.

Even between otherwise identical bonds from the same issuer, call risk can bump up the yield (and lower the price) slightly over the noncallable bond. For example, of two corporate bonds issued at the same interest rate and maturity date — one callable in eight years and the other noncallable — the callable bond offered a 0.2% higher yield.

Issuers may want to call a bond if interest rates drop, allowing them to pay off debt and issue new bonds at a lower rate. This process is similar to refinancing your home mortgage to get a lower interest rate and lower monthly payments. In the case of a bond call, unfortunately, the bondholder then needs to reinvest his or her money, probably at a lower rate. This happened in 1998, when interest rates fell and many issuers called their bonds so they could issue new ones at much lower rates. Bonds offering higher yields are particularly susceptible to being called. This was the case in the early 1990s, when high-yield "junk" bonds (those whose issuers are on questionable financial ground), were called in great numbers.

Occasionally, issuers may call a bond without warning if they fail to use investors' money for its stated purpose. For example, if a company issues bonds to raise money to buy new equipment and doesn't complete the purchase within a stated time, it may have an obligation to give investors' money back before maturity. However, the issuer must state when the bond is issued that they have this obligation. Your best protection is to ask whether the issuer can make these sudden calls.

Announcements of issues being called are usually made in major financial publications such as The Wall Street Journal. If you hold an electronically registered bond (most recent issues are registered), you will be notified. But if you hold a bearer bond — issued as a certificate, usually before 1983 — and don't read the financial press, you may not find out until too late. If you miss the call date, you may be penalized as much as six months' interest.

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What to Look for on Callable Bonds

• First call date — usually 5 or 10 years from date of issue.
• Different call prices specified for 5 years and 10 years.
• Slightly higher yields for callable corporate, Ginnie Mae, and municipal bonds.
• Issuer's stated right to call bond early without warning.

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Managing a Manageable Risk

Of all the risks facing a bond issue (others are credit risk, interest rate risk, and market risk), call risk may be the most manageable. Issuers must state a bond's first call date when issued, or specify that they have the right to call the bond later on. You may want to avoid buying a bond if it's close to a stated call date, especially if it's well above the minimum call price and interest rates are falling. Consider, too, the worst-case scenario: If the bond is called in 10 years at a stated call price, would it still fit your investment objective? For issuers that have the right to a non-warning call, research their history of exercising this right with previous bonds.

If you don't want the trouble of researching and tracking your bonds' call possibilities, an easy alternative is to invest in a bond mutual fund that matches your investment goals. That way, your money is diversified among several bond issues with a manager who may balance call and other bond risks with the fund's investment objective.

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How to Manage Call Risk

• Know your bond's first call date (the first date on which it can be called).
• Avoid bonds with call dates in the near future, especially if interest rates are falling.
• Know whether the issuer can call the bond without warning, and whether it has done so in the past.
• Consider whether the bond would still fit your investment strategy if it's called at the next call date.
• Follow the financial press for notifications of bond calls.
• Avoid "bearer bonds" if possible; you won't be personally notified if your issue is called.
• Invest in a bond mutual fund, where call risk and other risks are professionally managed.

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Call Risk Can Bring Opportunity

Mutual fund managers can turn up opportunities based on their knowledge of interest rate forecasts and the callable bond market. A period of falling interest rates can drive down the prices of bonds that are callable in the near future. A manager or individual investor who believes rates will rise again soon may find some bargain-priced issues in this callable group.

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Look Beyond the Call

Call risk is only one factor to look at in your bond investment decision. Changing interest rates are one of the chief risks to a bond's return. This is why you need to look at all of a bond's risks before making an investment decision. If you want to add income potential to your long-term growth portfolio, a corporate bond with a call date that's 10 years away may be preferable to lower-yielding Treasuries and their minimal call risk. Your financial advisor can help you decide whether a bond or bond fund's overall risk and reward potential are right for your investment goals.

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Points to Remember

1. Some bonds can be "called" before maturity; the first call date is set when the bond is issued. To protect investors, all dates are usually set for several years from issue. If a bond is called, the investor must surrender his or her issue, probably for an interest rate and price that differs from the return to maturity.
2. Investors are often compensated for "call risk" with relatively higher yields. Bonds most likely to carry call options include corporate bonds and Ginnie Maes, as well as municipal bonds. When an issuer sells two otherwise identical bonds, the callable issue can end up trading at a higher yield.
3. Falling interest rates entice issuers to call bonds, as they can redeem issues at lower prices and reissue them at lower interest rates. Some issuers may call a bond without warning if they fail to use investors' money as stated.
4. When an issue is called, it is often noted in major financial publications such as The Wall Street Journal. Investors in electronically registered bonds are notified personally. Not surrendering a called bond on time could mean a substantial loss of interest.
5. Because call risk can be managed by knowing if and when an issue can be called, this risk may not weigh as heavily as more uncontrollable factors such as interest rate risk.

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Financial planning services and investments offered through Ameriprise Financial Services, Inc., Member FINRA and SIPC.

There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Non-investment grade securities, commonly called "high-yield" or "junk" bonds, generally have more volatile prices and carry more risk to principal and income than investment grade securities.