CALIFO RNIA ISSUE BRIEF DEBT AND INVESTMENT California Debt and Investment Advisory Commission ADVISORY

COMMISSION MAY 2002

INVESTING IN CALLABLE SECURITIES

Robert Ingenito notably, investment in callable securities can CDIAC Policy Research Unit increase a portfolio’s “reinvestment risk” (that is, the risk of having to reinvest money In recent years, “callable” securities, in a lower interest-rate environment if the which contain options that allow issuers to original investment is called); consequently, retire them prior to their final dates, investors need to weigh the potential have gained usage among public fund benefits and drawbacks of such an investors. Their greater usage as a tool for investment. state and local investment officials largely can be seen in the wide variety of bonds This Issue Brief seeks to provide containing call features that are available for public investment officials with information public fund investment. For example, to assist them in evaluating callable corporations and U.S. Agencies both issue a securities relative to noncallable securities. variety of different types of callable bonds. It provides information on the key The increased use of callable securities is characteristics of callable securities, the due, in part, to the growing sophistication of potential advantages and disadvantages of financial markets. Over the past twenty incorporating them into an investment years, methods for comparing intricately portfolio, and how to assess their value structured investments have been developed compared to noncallable securities. It and refined, thus allowing public fund concludes with recommendations to investors to be able to more easily compare consider when deciding whether to invest in and better understand the risks and value of callable securities. these potential investment alternatives. Moreover, during times of lower returns on investment, callable bonds provide relatively higher returns than noncallable bonds I. An Overview of Callable because investors are compensated for the Features potential call risk they face without incurring additional credit risk. Callable securities are term bonds within which the issuer has the to However, while the higher yields retire the bonds prior to the final maturity of available on callable securities can be the issue. In such cases, the issuer is attractive for investors who can accept call enabled, during specific time periods, to risk in their fixed-income portfolios, these “call”, or repurchase, a away from the instruments can introduce other types of risk investor at a specified price. The action is that public investors should consider. Most entirely at the election of the issuer, with no recourse by the investors in the bonds. The

CDIAC 02-3 1 California Debt and Investment Advisory Commission Investing In Callable Securities call feature has a noticeable impact on the up” call structure. A step-up call will have a issuer’s cost of borrowing, and hence the call date at which point the issuer may retire returns achieved by public fund investors. it or the security will “step up” to a higher To compensate for the maturity uncertainty value. As an example, a step-up that an investor is assuming, the yields on callable security may have an initial coupon callable securities are at a premium over rate of 5 percent and then be called or those obtainable from fixed maturity debt stepped-up to 6 percent. with the same final maturity. Regulations Regarding Disclosure of Call Diversity of Call Types Features Corporations and U.S. Agencies Municipal Securities Rulemaking Board issue callable debt in a variety of forms; for (MSRB) Rule 12 and Rule 15a require example, the Federal Home Loan Mortgage broker/dealers to inform investors that an Corporation (Freddie Mac) alone reported investment has a and to provide issuing callable debt with 61 different call information about whether/how that option options in 2001. Final maturities typically may impact the investment’s value. range from one to thirty years. In addition, Specifically, in the case of callable all callable bonds have a period of time securities, the broker/dealer must provide during which the issuer cannot call the bond the /price of the lower of the following – the “lockout period”. The lockout period two scenarios: can be as short as three months or as long as ten years after the securities are issued. The 1) The bond’s yield/price to call, which securities can be issued with either single or assumes the bond is called, typically multiple call provisions. Popular types of at the next/first call date. call provisions include the following three popular types: 2) The bond’s yield/price to maturity, which assumes the bond is never • European Call. The bonds may be called and instead is held to maturity. called one time only on a pre-specified date after the initial lockout period. In addition, the broker/dealer must provide information on the date and the • Bermudan Call. The bonds may be yield/price of the bond’s next call. called according to a pre-specified schedule (e.g. monthly, quarterly, or semi-annually) after the initial lockout II. Underlying Objectives for period. Issuing Callable Bonds

• American Call. The bonds are The largest issuers of callable bonds continuously callable after the initial are corporations and U.S. Agencies. The lockout period. That is, they are callable U.S. Agency bond issues include: (1) at any time on or after the first call date. obligations directly issued by departments of the United States government, and (2) As is the case with investment obligations issued by entities chartered by products generally, the variations on the the United States Congress for the purposes basic call structures continue to grow. For of fulfilling a specific mission, most notably example, one variation includes the “step- the federal government’s various lending

CDIAC 02-3 2 California Debt and Investment Advisory Commission Investing In Callable Securities programs1. For these issuers, callable bonds Matching Assets and Liabilities play an important role in achieving two key Callable securities provide an objectives: opportunity to match assets and liabilities – one of the basic principles of investing. For Reducing the Cost of Funds example, U.S. Agencies commonly hold a Callable bonds lower issuers’ overall combination of mortgage-backed securities long-term cost of funding by providing them and loans in their portfolios. A unique the opportunity to refinance their debt when feature of mortgage assets is the right of the interest rates decline. The call option gives mortgagee to pay off the mortgage at any the issuer the right (but not the obligation) to time, usually for the purpose of refinancing redeem the bond after a specified lockout when interest rates decline. Consequently, period. A issuer has incentive mortgages, like callable bonds, contain an to redeem the bond (exercise the call option) embedded call option. Thus, for U.S. when the -determined yield of a Agencies, callable bonds on the liability side comparable new issue drops adequately of the balance sheet complement callable below the yield on the outstanding bond2. mortgages on the asset side (because each For example, a 20-year can be replaced with lower-cost debt as might be issued at a rate of 8 percent with a interest rates decline). provision that it can be called away from holders after five years. If, five years later, the for similar bonds has III. Factors Affecting Callable Bond dropped to 6 percent, the issuer may find it Pricing and Yield favorable to call the original bond and replace that debt with a less expensive 6 A local governmental entity that percent bond. Consequently, call invests in a callable security effectively is redemptions increase during periods when entering into two distinct transactions: the interest rates decline; issuers redeem purchase of a noncallable bond (also known outstanding bonds with relatively high as a “bullet”) and the sale of a call option to yields and replace them with newly issued the issuer. Thus, bonds with lower yields. Many issuers exercised their option to call their securities PRICEcallable = PRICEbullet – PRICEcall option in 2001 because of the continuous decline in interest rates that occurred for most of the This equation illustrates two key year. Thus, call redemptions reduce issuers’ things. First, the price of a callable bond overall long-term costs. must always be less than or equal to the price of a bullet security with similar terms (the difference will depend on the value of the call option to the issuer). Second, the price of a callable bond is influenced by 1 The five largest Agencies are the Federal Farm both (1) the same factors that affect the Credit System (FFCB), Federal Home Loan prices of bullet bonds and (2) factors that (FHLB), Federal National Mortgage Corporation affect only the price of the call option. (FNMA, “Fannie Mae”), Federal Home Loan Mortgage Corporation (FHLMC, “Freddie Mac”), and Student Loan Marketing Association (SLMA, “Sallie Mae”). 2 In this context, “comparable” means having similar risk and remaining maturity.

CDIAC 02-3 3 California Debt and Investment Advisory Commission Investing In Callable Securities

Conversely, the yield of a callable • Liquidity Risk. This risk relates to the bond must always be greater than or equal to ability to sell a security without taking a the yield of a similarly termed bullet: loss. Liquidity is higher when there is an active secondary market for the YIELDcallable = YIELDbullet + YIELDcall option security. For an investor who plans to hold the bond until the maturity date, This explains the primary motivation liquidity risk is less important. of why investors purchase callable bonds: • Level and Shape of the . the incremental yield pickup over bullet Because U.S. Agency and corporate securities of comparable risk and maturity. bonds are issed at a spread above the yields on U.S. Treasury bonds, the shape Bullet Price and Yield Considerations and level of the U.S. Treasury yield Several factors affect the price and curve (see Figure 1) has a significant yield of the bullet portion of callable bonds: impact on their pricing. For example, when the yield curve is very flat or • Credit Risk. U.S. Treasury bonds inverted (as was the case in 2000), possess the highest possible credit rating investors received only a small yield and are viewed in the marketplace as pick-up for extending a bond’s maturity. essentially free of default-risk. All other bonds, including U.S. Agency, Figure 1: Examples of the Yield Curve corporate, and municipal bonds, are considered “spread products” because they are issued at some spread above the yields on U.S. Treasury bonds due in Positive or “Normal” part to the incremental credit risk over Yields U.S. Treasury bonds. Flat Inverted • Market Risk. This refers to the impact that changes in the prevailing level of interest rates have on the market value of Terms to Maturity all outstanding bonds. When interest rates decline, bond prices rise, and when interest rates rise, bond prices decline. The Call Option Therefore, an investor holding a bond Several factors affect the price of the bearing interest rates higher than the new call option. They generally can be prevailing market interest rates will see summarized into two groups: the flexibility an increase in the value of the security of the call option (that is, the relative ease in (the converse is true for an investor which an issuer can call the security) and the holding a bond bearing interest rates likelihood that it will be exercised below the new prevailing market interest (commonly expressed as “come into the rates). Thus, longer-term securities have money”). greater market risk due to the chance for The more flexible the option is to the more market variation over a longer issuer, the more the issuer will pay for it period of time. through higher yields. Key factors affecting the flexibility of a call option include:

CDIAC 02-3 4 California Debt and Investment Advisory Commission Investing In Callable Securities

• Type of Option. To compensate for the • Interest Rate Volatility. The volatility of uncertain maturity of a callable security interest rates plays a significant role in that an investor assumes upon purchase, deciding whether the call option will be the yields on callable securities are set at exercised. In theory, the value of any a premium over that of a bullet or fixed option increases with the volatility of maturity debt with the same final interest rates. The greater volatility maturity. American call options provide means there is a greater chance that the greatest flexibility to the issuer, and interest rates will decline by a margin hence are the most valuable to them; sufficient for the issuer to replace the conversely, European call options are the higher yielding debt with lower cost least valuable. In other words, because debt. The likelihood that interest rates bonds with American call options may could rise is also greater with higher be called anytime after the lockout volatility, but there is no incremental period, issuers value them more than loss to the issuer when rates move higher those that can be called less frequently, because they can simply choose not to and are willing to pay a higher yield. exercise the option. In other words, Thus, investors apathetic to call option while the potential loss to the issuer is type (all other considerations being limited as volatility increases, the equal) can receive additional yield by potential gain is not. Thus, issuers will purchasing a security with an American pay more for call options through higher call option. yields and lower bond prices when interest rate volatility is high or expected • Lockout Period. All callable securities to be high during the term of the bond. have a period of time that the issuer cannot call the bond. The beginning of • Shape and Level of the Yield Curve. the lockout period is the bond’s The shape of the yield curve affects the settlement date and typically will be a price of the call option too. A rising period from three months to ten years. yield curve (i.e., increasing rates for The shorter the lockout period, the longer maturities) implies that interest greater the issuer’s flexibility to call the rates are expected to increase. The more bond and the more valuable the call steeply or positively sloped the yield option is to the issuer. Therefore, bonds curve, the stronger the suggestion that with shorter lockout periods will tend to interest rates will rise. A flat yield curve have higher yields and lower bond prices implies no expected change in interest than those with longer lockout periods to rates, while a declining, or inverse, yield compensate the investor for the issuer’s curve implies an expectation of greater call flexibility. declining long-term interest rates. The value of the call option will be lower the Similarly, a call option is more greater the upward slope of the term valuable as the probability that it will be structure. This is because the likelihood exercised increases. As call option prices of a profitable decline in interest rates is increase, the price of a callable bond more remote the more positive the yield declines. Key factors affecting the curve. A nearly flat or negative term likelihood that the call option will be structure will tend to result in a larger exercised (or “come into the money”) option value. include:

CDIAC 02-3 5 California Debt and Investment Advisory Commission Investing In Callable Securities

IV. The Investor’s Potential compensated for these features by the issuer via either a call premium and/or a higher Benefits and Disadvantages for 3 Investing in Callable Bonds yield. Potential Disadvantages of Investment Potential Benefits of Investment At the same time, the public investor From the viewpoint of the public funds faces several potential disadvantages investor, callable securities have the associated with callable bonds: following potential benefits: • Reinvestment Risk. The issuer of a • Additional Yield. Callable bond callable security likely will call the bond investors typically must be should prevailing yields “compensated” for the risks associated drop below the rate on the outstanding with purchasing bonds that may be callable bond. When the issuer calls the retired before maturity. One form of bond and returns the principal and compensation is higher yields on accrued interest to the investor, the callable securities relative to noncallable investor is faced with reinvesting the securities. money in a lower interest rate • environment. If that occurs, the investor Constant Credit Risk. The call option will be unlikely to find another security on a callable security does not increase of similar quality that will provide as the credit risk of the obligation because high a yield. it does not directly affect the issuer’s ability to repay its debt. • Cash Flow Uncertainty. The investor who purchases a callable security does • Premium Payments. The higher yield so without knowing in advance whether alone is often not sufficient a bond will be called and under what compensation to the investor for terms. Thus, the cash flow stream on a granting the call privilege to the issuer. callable bond is somewhat Thus, the price at which the bond may unpredictable, and is dependent on the be called, termed the call price, is call feature and structure. For example, normally higher than the principal or cash flow uncertainty is much larger “face value” of the issuer, at least for the with a security that can be called earlier dates upon which the call option continuously after one year than one that can be exercised. The difference can be called only one time over five between the call price and the face value years. is the “call premium”.

Some callable securities are issued at • Price Compression (or Negative a discount and have par call features, while Convexity). As discussed above, a other issues may have a premium call that bond’s price and its yield have an declines as it approaches maturity. inverse relationship. However, that Corporate issuers generally issue callable relationship is not constant – that is, a securities that will be called at a premium over par, while the bulk of U.S. Agency 3 Measuring the value of the calls on callable issues is issues have par calls. Regardless of the call a very difficult calculation and goes far beyond simple credit and interest rate risk measures. This is feature, the investor must be adequately addressed in the next section.

CDIAC 02-3 6 California Debt and Investment Advisory Commission Investing In Callable Securities

bond’s price does not increase in a one- • Yield-to Maturity. The yield-to-maturity to-one relationship as interest rates calculation assumes (1) that the security decline. In a lower interest rate is not called and (2) the investor holds environment, investors can increasingly the bond to its final maturity date. The expect issuers to redeem outstanding yield is calculated from the cash flow at bonds. However, as interest rates maturity and the interest payments decline, the price appreciation of a generated by the bond (reinvested at a callable bond is limited – price increases rate equal to the bond's yield-to- at a slower rate relative to the decline in maturity). interest rates. This disadvantages investors trying to sell callable bonds • Yield-to-Call. The yield-to-call prior to the call date. This is sometimes calculation assumes that the bond is referred to as “price compression” or called on the next eligible call date. The “negative convexity.” yield is calculated from the cash flows from the coupon payments plus the cash • Increased Accounting Complexities. flow of the redemption proceeds at the Because the issuer can redeem callable time of the call. securities prior to their final maturity date, they present an increased level of • Yield-to-Worst. A more conservative complexity for local governmental alternative to the yield-to-call method is jurisdictions’ accounting staffs with the yield-to-worst method. Many bonds respect to . Local treasurers are continuously callable after their first should confirm with their accounting call date (typical of American-style call staff that they have the ability to handle features). Because of the uncertainty of such investments. the call date, the yield-to-worst method was developed. To derive a yield-to- Given these potential benefits and worst, a yield-to-call is calculated for the disadvantages, it becomes important for initial call date and each coupon investors to evaluate whether the risk-return payment thereafter. Additionally, a profile of a particular callable bond is yield-to-maturity calculation is also suitable for their investment portfolio before performed. The yield-to-maturity investing in it. As part of the measurement calculation and all of the yield-to-call of potential benefits, investors need to assess calculations are then reviewed and the the value of the callable security versus lowest yield from the group becomes the other comparable instruments. yield-to-worst.

When making purchase decisions based V. Valuing Callable Securities upon yields it is important to understand which of the three methods has been used in Yield Calculations deriving the stated yield and how rate The yield on callable securities is not changes will affect the final yield calculated via a single formula. Instead, performance of the security. When there are three methods of calculating yield prevailing interest rates are higher than the in common use: coupon on the bond, it is assumed that the issuer will not call the bond, and yield-to- maturity is most commonly used.

CDIAC 02-3 7 California Debt and Investment Advisory Commission Investing In Callable Securities

Conversely, when prevailing interest rates Option Adjusted Spread are lower than the interest rate on the issue, Today, it is common for fixed it is assumed that the issuer will call the income investors to employ option-pricing bond, and yield-to-call is most commonly techniques to value embedded options and used. adjust their valuation of the related securities accordingly. Thus, instruments Measuring Relative Value – Option are compared no longer according to their Adjusted Spread absolute yields, but according to their One of the challenges that investors "option-adjusted spreads”. These methods face today is comparing the relative value of determine the component of a security's one fixed income investment to another. yield that is attributable to imbedded Prior to the 1970s, investors used more options. In other words, when the Treasury simple methods such as yield comparisons yield and other non-option related risk for analyzing fixed income instruments with factors are subtracted out, the result is the imbedded options because: OAS.

• The structuring of fixed income The benefit of the OAS is that it instruments was more uniform than it is enables investors to measure their today. compensation for accepting an and the risks that come with it. • Interest rates were less volatile, so Investors can compare the OAS of a callable imbedded options were worth less. debt security to the option-adjusted or bullet spreads of other fixed-income securities • A reliable method for valuing options when making investment decisions. had not yet been developed. Callable securities are usually priced Since the 1970's (as inflation rates and evaluated using an OAS framework increased), however, interest rates have similar to that used for other option- become significantly more volatile, and a embedded securities that have cash flows wider variety of fixed income instruments that are sensitive to changes in interest rates. have come into use. Comparing relative Because a callable security consists of a yields of callable securities to noncallable bullet component and a call option securities may prove misleading as the component, OAS provides an investor with callable instrument's yield will be inflated to a methodology to analyze a callable debt compensate investors for the call option security by isolating the yield premium imbedded in the instrument. Many associated with the call option. The OAS of investments today entail complex embedded a callable debt security is expressed as a options, which make measuring a security’s spread over the Treasury curve. The OAS relative value more difficult. A sophisticated analysis framework is based on a forward method for valuing fixed income options interest rate curve, certain volatility valuation was developed to address these assumptions, and the current security price. complexities—it is known as the Option An OAS model generates the average spread Adjusted Spread (OAS). to the forward interest rate curve under a number of potential interest rate paths.

CDIAC 02-3 8 California Debt and Investment Advisory Commission Investing In Callable Securities

For many fixed-income investors, box accordingly. As with purchasing OAS is one of the most useful and operating in-house software, measurements for assessing value in a however, the cost of purchasing a callable security. Nevertheless, option Bloomberg terminal may be prohibitive pricing still remains largely more art than to many public-fund investors that do science. A security’s OAS will depend not not already have them. only upon the characteristics of that particular security, but also upon the • Seek Information from Broker/Dealer assumptions (such as the volatility of or Investment Advisor. Investors can interest rates) incorporated into the option ask their broker/dealer for OAS pricing model.4 Therefore, the accuracy of information for securities they are the underlying OAS assumptions plays a interested in purchasing. Broker/dealers significant role in the effectiveness of the and investment advisors generally have model’s estimates. access to Bloomberg or other software that provides such information. While The actual OAS calculation is the information may not be as readily complicated and requires software and available as in the above two cases, technical knowledge to achieve accurate investors can minimize costs and obtain results. Investors have several options for assistance from broker/dealers and obtaining OAS information: investment advisors in the interpretation of the results. • Obtain OAS Software for In-House Use. Various software is available for calculating OAS. While operating such VI. Recommendations software in-house would provide information readily to the public Callable securities do not perform investor, the cost of purchasing and uniformly in changing interest rate climates. operating such software may be When interest rates are either stable or prohibitive. rising, callable securities will tend to be left • outstanding to maturity; conversely, when Use Bloomberg Terminal for interest rates are declining, they may be Information. Investors with access to called, requiring investors to reinvest the Bloomberg terminals can analyze option proceeds under relatively less favorable adjusted spreads through the OAS1 conditions. For investors who can accept screen by entering a yield curve, implied maturity uncertainty in their fixed income volatility and price, and setting the portfolios, the higher yields available on "Calculate" box to "O" for OAS. The callable bonds can be attractive. However, price or volatility can be calculated investing in callable securities requires more instead of the OAS just as easily by of a commitment to understanding the plugging in the remaining two various nuances of the investment than does parameters and changing the "Calculate" investing in bullet securities. These nuances include discerning the impact of a call 4 Volatility represents the amount of interest rate premium and the valuation of the callable fluctuation that is expected over a given period of security using such tools as OAS analysis. time. The expectation of future rate volatility may be As with all investments, both benefits and influenced, or determined in part, from historical measures of volatility.

CDIAC 02-3 9 California Debt and Investment Advisory Commission Investing In Callable Securities disadvantages should be considered before investing in such instruments.

CDIAC believes that public investors should consider the following checklist when deciding whether or not to invest in callable securities:

• Determine whether the investment meets the general risk tolerance levels specified in the local agencies’ investment policies and is acceptable for their current portfolios.

• Evaluate the specific benefits and disadvantages of the investment, including the , call premium, reinvestment risk, and cash flow uncertainty.

• Obtain an OAS or similar analysis and compare the results to other investments that the local agency may be considering.

CDIAC 02-3 10 California Debt and Investment Advisory Commission CALIFORNIA DEBT AND INVESTMENT ADVISORY COMMISSION 915 CAPITOL MALL, ROOM 400 SACRAMENTO, CA 95814 (916) 653-3269

Permission is granted to photocopy this document with credit given to CDIAC.