When your bonds come a calling

The Sterling Report

BY YANIQUE LEIBA-EBANKS

Sunday, November 10, 2019

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A callable bond allows the issuer to redeem or buy it back before it has matured. Typically, you will be given a fact sheet which tells you the dates or date ranges when the bond can be called; this is usually accompanied by the price at which they will buy back the bond from the investor.

The prospectus is likely to contain a call schedule where they may indicate different buy-back prices depending on when in the schedule the bond is called.

Generally, the sooner in a bond's lifespan that it is called, the higher the buy-back price is likely to be relative to the quoted buy-back prices later in the bond's life.

You may be wondering why some bonds are designed with this feature.

One of the main reasons is to allow companies to manage their finances. Many times, they have borrowed the money when interest rates were high. They wisely recognise that rates may decrease in the future and place a clause that allows them to refinance (pay off the expensive debt and issue new debt) without too much fuss. In that way they can reduce their interest expense.

There are several considerations for an investor to take into account.

The main one is the price at which they are purchasing the bond. Let me give you an example. Suppose you want to buy a bond at a price of 104 but it has a call schedule which is under two years with a price of 101. Unfortunately for you, if the bond is called — you are going to lose out. So, the purchase price becomes very important, as well as the call date.

If the call date is very far in the future, it may not play as large a role since many things could happen before then. Most times, traders are very conscious of the features, so callable bonds may trade in a narrow range close to the call price when the market feels that the bond will be called in the near future.

There really is no way of knowing whether a company will utilise the call feature or not, since interest rates may have fallen, but the company may not want to go to the expense of refinancing and the fortunes of the company may have fallen, ie they may doubt whether they will receive a favourable reception when raising new money and hold off on calling the bond.

As it is, if the bond is called, you as the investor are forced to sell it and this is not optional.

THE GOOD, THE BAD, AND THE UGLY

Callable bonds can be good for investors if the bond has a very long maturity, and the investor has other investment opportunities they would like to pursue.

In addition, all things being equal, a callable bond compared to a non-callable bond should have a higher coupon rate than the comparable non-callable bond, so the investor is partially compensated for the possible disadvantage.

However, if rates have fallen and the investor has no attractive opportunities, they may experience a huge dip in their coupon income as a result.

As with any investment, do your due diligence before you proceed, but a callable bond is not necessarily good or bad.

Yanique Leiba-Ebanks, CFA, FRM, BSBA, is the AVP, pensions & portfolio investments at Sterling Asset Management. Sterling provides financial advice and instruments in US 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 info@sterlingasset.net.jm.


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