In a falling interest rate environment or in one where interest rates have fallen in the not-too-distant past, it is especially important for investors to understand bond calls if they own individual bonds, bond funds, annuities or life insurance.

Investments in bond funds or insurance companies still ultimately represent investments in portfolios of individual bonds. The underlying bonds comprising the portfolios may be subject to calls (early redemptions) that will affect the cash flow from bond funds and annuities. Investors may not see the effect of these calls because these entities may replace high-coupon bonds they bought at par (the face value of the bond, or $1,000) with high-coupon bonds they purchased at a premium to face value. The payout of distributions from the bond funds and annuities might be similar. However, instead of receiving mostly interest income, investors are also receiving a portion of their principal investment. High-yielding bonds are being replaced by bonds paying less interest. Insurance companies that rely on interest income for their fees and expenses will have to pass those expenses onto the policyholders.

The Process Described

Here is an example of the effect of calling bonds issued by the school board of a small rural school district located in northwest Ohio outside of Lima in Allen County to construct a new high school and improve school facilities by acquiring land, improving the building sites and furnishing and equipping the facilities. The school board manages four school buildings, administrative offices and a transportation authority.

The initial project cost $38.2 million, but the school district was able to refinance (redeem and replace) only $26.5 million of the original $38.2 million bond issue. The refinance reduced the average interest rate cost from 4.8% to 3.3%. It is expected to save taxpayers $2.1 million over 20 years. That means that bondholders who anticipated earning an additional $2.1 million on their investment will not be receiving those interest payments.

Treasurer Joel Parker was quoted in The Lima (Ohio) News and reported in The Bond Buyer as stating: “Just like on your own personal home, it gets to a point where it’s advantageous to take advantage of market interest rates dropping, which is what we did.”

How to Think About Bond Calls (Prepayments)

When you own a house and see interest rates drop, it may be wise to refinance your mortgage to reduce what you will have to pay if you plan on staying for the long term. When you purchase a bond, you take the role of the bank, lending money to corporations, the federal government or state and local entities. When you purchase a certificate of deposit (CD) you are lending to a bank. Just as your mortgage document outlines how and when you can refinance, the prospectus or offering statement that accompanies every bond outlines when and how the bond issuer can exercise their call option. This is also known as an optional redemption.

If your bond is called, on the call or redemption date the issuer will pay you either the par value of the bonds or, in certain cases, a premium (e.g., 102, meaning $1,020 per bond), if that was agreed upon in the original offering.

On your brokerage statement, bonds that have been called will be marked with an (F) for full call. If they are marked with (P), then the interest income has been prepaid into a special fund that will be used to call the bonds on the first future call date. In bond lingo, this is called pre-refunding.

The issuer redeems bonds to save money. The savings generally must cover the cost of issuance of new refunding bonds. Refunding bonds are issued first and then the outstanding bonds are redeemed.

You lose because you may have to reinvest in new bonds at a lower interest rate. Note that bonds are less likely to be called in a rising interest rate environment. Nevertheless, they can be called under any circumstance.

Laddering Bond Calls

To reduce the probability of having many bonds prepaid at the same time, it is wise to ladder calls as well as maturities. When bond calls are laddered, the call dates are spread over a number of years. Initially, the calls usually fall between five to 10 years from the time of purchase. Time passes quicker than you might think and soon every year has bonds potentially callable.

Bonds with shorter call dates would have lower yields to worst than bonds with longer call dates. [Yield to worst is the lowest possible yield that could be earned by purchasing the bond and holding it until it is called.] In Table 1, you can see how two bonds from the same issuer, separated by little more than a year in the final maturity, can have substantially different yields to worst. The difference exists because one call date is two years and four months shorter than the other for a yield. The results a 0.539% higher yield to worst for the bond maturing in 2041. The yield to maturity, meanwhile, is only 0.128% higher for this bond.

Kinds of Bond Calls

There are four kinds of bond calls:

• the fixed call and
• three types of unscheduled calls—
  • extraordinary call for a defined reason,
  • sinking fund, and
  • make whole call.

A particular type of bond issue may have more than one kind of call, as seen in Table 2. It is imperative to ask about unscheduled calls when buying bonds by asking specifically about each type.

Table 1. The Effect of Call Dates on Yields

Table 2. Types of Calls by Bond Type

The Fixed Call

A fixed call is just that: It is fixed to begin on or any time after a specific date. The issuer decides if it is advantageous to redeem, or call, the bonds before the final maturity date. Your bonds cannot be called before the specified call date if this is the only call option.

Each type of bond has its own pattern. Federal agency bonds, for example, may provide call protection for six months to three years at issuance, or they may be non-callable altogether. Municipal bonds, on the other hand, usually have between eight to 10 years of call protection when they are first issued. To have call protection means that your bonds cannot be called by the issuer before the first stated call date.

If municipal bonds have 10-year call protection, the first call date is 10 years after the date of issuance. For example, if a bond with 10-year call protection was issued on October 15, 2015, then the issuer has the right to stop paying interest and return your principal investment on October 15, 2025.

In a particular issue with serial bonds (bundles of bonds with differing maturities), all the bonds set to mature before that date cannot be called before that date. All the bonds set to come due after the call date can be called, usually on any interest payment date after the first call date.

Bonds that start out with 10-year call protection have only nine-year call protection after one year. Traders often sell bonds when the bonds have only five years of call protection remaining.

Unscheduled Calls

When you ask about bond calls at the time of purchase, you might be told about the fixed calls. But you may not find out about the unscheduled calls because they may not appear in the short description. These calls include extraordinary calls, sinking fund calls and make whole calls.

These calls are generally not used to calculate the yield to call (yield to the earliest call date) because they are all unscheduled. However, if you understand the nature of these calls, you will be able to make better investment decisions.

Extraordinary Calls

An extraordinary call is a call that gives the issuer the right, but not the obligation, to call the bonds when there are certain triggering events. For example, if a municipal housing bond issuer has unexpended funds, they may be able to call bonds early. In fact, in the case of housing bonds, the housing agency may be required to call bonds when there is extra cash. If the bonds were issued for construction of a building, the bonds might be able to be called if there were a fire or some other calamity. Water and sewer bonds usually have this call as well.

The Build America Bonds (BABs) are a prime example of bonds with an extraordinary call. BABs are taxable municipal bonds that were issued for a short period beginning in 2010 at the height of the financial crisis as a way of helping municipalities retain solvency during the Great Recession. Many BAB’s have extraordinary calls that can be activated if the federal government were to fail to pay the promised 35% of the issuer’s interest payments. This event actually occurred as a result of the federal government’s sequestration (automatic budget cuts), and several issuers activated this call. Sequestration resulted in the federal government reducing the interest paid on BABs from 35% to 28%. This suddenly made most of these bonds potentially callable. Some issuers immediately acted and called in the high-coupon bonds and issued new bonds to replace them. Most issuers did not; however, that does not mean they will not call in their bonds sometime in the future.

Sinking Fund

A sinking fund is a fund, established by the issuer and recorded in the bond indenture, that accumulates cash to pay off bonds at some future date. This is a mandatory payoff that will occur. Unlike all other calls that may not be exercised, the sinking fund is activated to smooth out payments in the years preceding the longest-term bonds. It may begin about five years before the final maturities of serial bonds or of term bonds (stand-alone bonds that may not be part of a series).

The issuer may satisfy the terms of the sinking fund by purchasing bonds in the open market or by calling outstanding bonds by lottery. If you purchase your bonds at a premium to face value, a sinking fund may negatively affect your outcome if your bonds are called. If you know about the sinking fund, you can calculate the yield to worst to the first possible call date to see if that is acceptable to you.

Make Whole Calls

These calls are frequently found in corporate bonds and municipal bonds that are subject to federal taxation. They are designed to make whole the buyer who purchased the bonds as a new issue.

If the bonds are called, the issuer must pay a penalty pursuant to a stated formula. The penalty often makes exercising of this call so expensive to the issuer that it is used infrequently. However, if you purchase bonds with this call in the secondary market that are selling at a large premium, it is wise to ask how your return might be affected if this call is activated. You may end up losing some of the premium you paid.

The Impact of an Extraordinary Call

Housing bonds, like most Build America Bonds, have extraordinary calls. Here is an example for a bond we considered purchasing on January 14, 2016.

The South Carolina Housing Finance and Development Authority issued federal and state taxable mortgage revenue bonds rated Aa1 by Moody’s. The coupon is 3.401% and the due date of the bond July 1, 2022, to yield 3.078% with a market price of 101.873 on that date. This bond has no fixed call, but does have an extraordinary call, which can be exercised on any interest payment date.

If we were to have purchased 10 bonds at a price of 101.873, the cost would be $10,187. We would have paid a premium of $187 for the 10 bonds. When we looked at the material events—happenings that would affect the value of the offering—we noted that the issuer had exercised its right to call some of the bonds by publishing a notice on December 2015. Since there was already one call on these bonds, there was a high likelihood that there would be further calls. If the bonds were called in July of 2016 instead of at maturity in 2022, the yield would be –0.746% instead of the 3.078% yield to maturity because we would have held the bonds less than six months and had paid a premium.

Conclusion

In order to understand investing in bonds, whether you purchase individual bonds or bonds through a mutual fund or exchange-traded fund (ETF), you need to understand how bond calls will impact your investment. If you buy individual bonds, you can determine the yield to call as well as the yield to maturity of the bond. You will not be able to determine the yield to call if you buy bond funds or bond ETFs, but understanding the impact of calls on your bond portfolio will provide additional information that you may use to make decisions about your financial life.

We described how an issuer decides to refund an outstanding issue. We outlined the primary types of bond calls: fixed calls and unscheduled calls. We described three types of unscheduled calls that might not be mentioned if you just ask about bond calls, namely: extraordinary calls, sinking fund calls and make whole calls.

Now that you are alerted to these calls, we hope you can make wiser purchasing decisions.

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