Callable bonds - because they carry the risk of being cashed in early - often have a higher coupon rate. Although this may make callable bonds more attractive, call provisions can come as a shock. Even though the issuer might pay you a bonus when the bond is called, you could still end up losing money. Plus, you might not be able to reinvest the cash at a similar rate of return, which can disrupt your portfolio. Here we look at how a call can cause losses, what to look for in a callable bond and how to prepare for the possibility of your bond being called.

How You Can Lose Money
Let's look at an example to see how a call provision can cause a loss. Say you are considering a 20-year bond, with a $1,000 face value, which was issued seven years ago and has a 10% coupon rate with a call provision in the 10th year. At the same time, because of dropping interest rates, a bond of similar quality that is just coming on the market may pay only 5% a year. You decide to buy the higher-yielding bond at a $1,200 purchase price (the premium is a result of the higher yield). This results in an 8.33% annual yield ($100/$1,200).

Suppose that three years go by, and you're happily collecting the higher interest rate. Then the borrower decides to retire the bond. If the call premium is one year's interest, 10%, you'll get a check for the bond's face amount ($1,000) plus the premium ($100). In relation to the purchase price of $1,200, you lost $100 in the transaction of buying and selling. And once the bond is called, your loss is locked in.

What to Look for
When you are buying a bond on the secondary market, it's important to understand any call features, which your broker is required to disclose in writing when transacting a bond. Usually call provisions can be inspected in the issue's indenture.

When analyzing callable bonds, one bond isn't necessarily more or less likely to be called than another of similar quality. You would be wrong to think only corporate bonds can be called. Municipal bonds can be called too. The main factor that causes an issuer to call its bonds is interest rates (we look at this more below). One feature, however, that you want to look for in a callable bond is call protection. This means there's a period during which the bond cannot be called, allowing you to enjoy the coupons regardless of interest rate movements.

Before buying a callable bond, it's also important to make sure that it in fact offers a higher potential yield. Find bonds that are non-callable and compare their yields to callable ones. However, locating bonds without call features might not be easy, as the vast majority tend to be callable.

Finally, don't get confused by the term "escrow to maturity." This is not a guarantee that the bond will not be redeemed early. This term simply means that a sufficient amount of funds, usually in the form of direct U.S. government obligations, to pay the bond's principal and interest through the maturity date is held in escrow. Any existing features for calling in bonds prior to maturity may still apply.

Don't Wait Until Interest Payments Stop
If you own a callable bond, remain constantly aware of its status so that, if it gets called, you can immediately decide how to invest the proceeds. To find out if your bond has been called, you will need the issuer's name or the bond's CUSIP number. Then you can check with your broker or online at: (the service is free but requires registration).

Be Prepared
As we mentioned above, the main reason a bond is called is a drop in interest rates. At such a time, issuers evaluate their outstanding loans, including bonds, and consider ways to cut costs. If they feel it is advantageous for them to retire their current bonds and secure a lower rate by issuing new bonds, they may call their bonds. If your callable bond pays at least 1% more than newer issues of identical quality, it is likely a call could be forthcoming in the near future.

At such a time, you as a bondholder should examine your portfolio to prepare for the possibility of losing that high-yielding asset. First look at your bond's trading price. Is it considerably more than you paid for it? If so, it may be best to sell it before it is called. Even though you pay the capital-gains tax, you still make a profit.

Of course, you can prepare for a call only before it happens. Some bonds are freely callable, meaning they can be redeemed anytime. But if your bond has call protection, check from what date the issuer can call the bond. Once that date passes, the bond is not only at risk of being called at any time, but its premium may start to decrease. You can find this information in the bond's indenture. Most likely a schedule will state the bond's potential call dates and its call premium.

Finally, you can employ certain bond strategies to help protect your portfolio from call risk. Laddering, for example, is the practice of buying bonds with different maturity dates. If you have a laddered portfolio and some of your bonds are called, your other bonds with many years left until maturity may still be new enough to be under call protection. And your bonds nearer maturity won't be called, because the costs of calling the issue wouldn't be worth it for the company. While only some bonds are at risk of being called, your overall portfolio remains stable.

The Bottom Line
There is no way to prevent a call. But with some planning, you can ease the pain before it happens to your bond. Make sure you understand the call features of a bond before you buy it, and look for bonds with call protection. This could give you some time to evaluate your holding if interest rates experience a decline. Finally, to determine whether a callable bond actually offers you a higher yield, always compare it to the yields of similar bonds that are not callable.

Related Articles
  1. Bonds & Fixed Income

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  2. Bonds & Fixed Income

    Perpetual Bonds: An Overview

    A perpetual bond makes interest payments to the investor forever. This type of bond holds a certain appeal to both the issuer and buyer.
  3. Bonds & Fixed Income

    The Wonders Of Convertible Bonds

    Ever wondered what exactly a convertible bond does? Read the features of a convertible bond and learn how important the conversion factor is to you as an investor.
  4. Economics

    Why Governments Issue Foreign Bonds

    Government bonds issued in foreign currency have drawn a growing amount of interest in recent years. This article explores why governments, particularly those in emerging markets, choose to denominate ...
  5. Forex Education

    The Ins And Outs Of Corporate Eurobonds

    Corporate eurobonds simplify expansion for MNCs, though there are a few more hoops to jump through.
  6. Mutual Funds & ETFs

    Top 3 Inflation Protected Bond Mutual Funds

    Learn about the characteristics and suitability of the top inflation-protected bond mutual funds, and how investors can use these funds to their advantage.
  7. Stock Analysis

    The Biggest Risks of Investing in Apple Stock

    Read about the biggest risks facing Apple, Inc., and why AAPL investors should always be prepared for the day when the tech giant starts to struggle.
  8. Stock Analysis

    Top 5 Companies Owned by Ford

    Discover some of Ford Motor Company's most important subsidiaries and joint ventures, and learn more about what they do to further Ford's business interests.
  9. Stock Analysis

    Top 5 Companies Owned by Exxon Mobil

    Learn more about some of the biggest subsidiaries and joint-venture companies in the Exxon Mobil family, including both domestic and international businesses.
  10. Investing

    Binary Options For Capital-Protected Investments

    Binary options may sound complex, but they can be used to create capital-protected investments. Here's how.
  1. Why do bond coupon rates vary so greatly?

    There are two major reasons coupon rates vary: changes in market interest rates and the creditworthiness of the issuer. Newly ... Read Full Answer >>
  2. What are the advantages of investing in a callable bond?

    The biggest advantage of investing in callable bonds is that the issuer almost always offers a higher interest rate than ... Read Full Answer >>
  3. How safe are variable annuities?

    Life insurance companies are facing a challenging environment. Those that sell variable annuities have been able to mitigate ... Read Full Answer >>
  4. Why are mutual funds subject to market risk?

    Like all securities, mutual funds are subject to market, or systematic, risk. This is because there is no way to predict ... Read Full Answer >>
  5. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  6. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!