AS the investment landscape changes, the recent increase in the benchmark interest rate by the Federal Reserve has presented fixed-income investors with both opportunities and challenges. Market noise has left many investors uncertain about what to do, where to invest, and how to position their portfolios to withstand the current volatility. Now imagine that, under these circumstances, you have been quietly and comfortably receiving steady income from a bond in your portfolio when you receive an advisory email stating that the bond has been called early. What does that mean? What should you do? In the words of Chicken Little, is the sky falling?

Callable bonds give issuers the right to repay a bond’s principal before its scheduled maturity date. When an issuer exercises this right, it effectively shortens the duration of the investment and, by extension, the investor’s income stream. However, if you are about to receive an early principal repayment the answer to the questions above may be more positive than you think. In a rising interest rate environment an early bond call can provide an opportunity to reposition your portfolio and potentially improve your future income.

DON’T LEAP WITHOUT LOOKING

The first step is to assess your overall portfolio and financial goals. What role did the now-called bond play in achieving those goals? How quickly do you need to replace the lost income? Once you understand your current position you can plan and execute your next move more efficiently. In the present environment the Federal Reserve is expected to implement another rate increase this year. If immediate income is not your highest priority you may consider temporarily holding the funds in short-term, liquid instruments. Treasury bills, repurchase agreements and other suitable liquid investments may be appropriate at this time. This approach offers two potential benefits. First, the funds can continue to earn interest while you wait for better opportunities. Second, keeping the investment term short provides greater flexibility to reinvest when yields become more attractive, without locking up your capital at present rates for the long term.

COUPON REPLACEMENT

When you are ready to purchase a replacement bond it is important not to focus solely on the coupon rate. A bond with a higher coupon is not automatically a better investment than one with a lower coupon. You are also investing in a different interest rate environment in which prevailing rates, although rising, may still be lower than the rate on your original called bond. It is therefore important to resist the temptation to select a bond strictly because it offers a high coupon. A prudent investor will also consider the issuer’s credit rating and the liquidity and duration risks associated with the new bond. The goal is to replace your income intelligently, not to assume excessive risk to recover every dollar of lost interest.

ALL IS NOT LOST

When purchasing a new bond you may be able to maintain your previous income by buying a greater face value, even if the new bond offers a lower coupon rate. Holding a larger face value can help offset the reduced coupon and preserve the desired income stream. The current environment may also present opportunities because many investment- grade bonds are trading at lower prices or below par. This reflects a fundamental principle of fixed-income investing, that is the inverse relationship between interest rates and bond prices. When market interest rates rise, the prices of existing fixed-rate bonds generally decline because newly issued securities offer more attractive yields.

What may initially seem like an unwelcome interruption or even the sky falling may, in fact, be a blessing in disguise. Use the opportunity to review your portfolio with the help of a licensed financial advisor. A bond call can provide a chance to make a strategic adjustment that better supports your financial goals.

Christine Rankine is assistant vice-president – personal financial planning, 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

Christine Rankine .