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 maturity 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 Security 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 option 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 bond 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 coupon 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 call option 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 yield/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 callable bond 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 market-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 corporate bond 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 interest rate 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 Bank 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 Yield Curve. the incremental yield pickup over bullet Because U.S.