A call feature on a bond is an option granted to the obligor to redeem their debt before the maturity date. (For more information on defining a call option, please ask your Raymond James Financial Advisor to provide related educational content.) This option favors the issuer, not the investor. Why? Because the issuer is in control, and they will not choose to exercise their option unless it is in their favor.
Suppose a corporation issues 10-year debt with a 4.0% coupon. They are obligated to pay 4.0% interest on the outstanding debt for 10 years before paying investors back their face value at maturity. If interest rates rise during the 10 years, the corporation is better off continuing to pay 4.0% interest rather than a higher current rate. However, if interest rates were to fall to, say, 2.0%, the corporation may benefit by calling or redeeming the bond and reissuing new debt at the lower 2.0% interest rate.
We are often asked about the likelihood of a call being exercised. It is not an exact science, as many variables are taken into consideration. The act of exercising a call comes with costs, paperwork, and time, which may negate any advantage gained for the issuer. The size of the outstanding debt may not warrant the overall savings from lowering interest paid. Legal or regulatory constraints may also dampen the benefits. All of these factors can vary from entity to entity.
As a general rule of thumb, if a bond’s market price is above par (100), it is “in-the-call.” That means that the current interest rate is lower than the coupon being paid. If the variance between the coupon being paid and the current rate of interest is wide enough, the issuer may be incentivized to exercise the call. The higher the coupon on a bond, the more likely it is that a call will be exercised.
Not all bonds are callable, and not all calls are alike. As a high percentage of bonds issued contain a call option, it may not be practical or financially beneficial to avoid them. Oftentimes, investors are rewarded with higher yields when the added risk of a call is present. Utilizing bonds with call options can significantly enhance the overall return on a portfolio. Understanding the risk of the call is paramount. Yields are quoted to maturity and to the call, which may allow investors to establish an acceptable reward for the risk they take. Layering call dates may enable an investor to ladder potential redemption dates, much like laddered maturity dates.
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The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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