Fixed-income investors in low-interest rate environments often discover that the higher rate that they are receiving from their current bonds and CDs doesn't last until maturity. In many cases, they will receive a notice from their issuers stating that their principal is going to be refunded at a specific date in the future. Bonds that have call features provide this right to issuers of fixed-income instruments as a measure of protection against a drop in interest rates. This article explores the options for investors who suddenly find themselves sitting on a pile of cash as a result of a called bond.

SEE: Bond Call Features: Don't Get Caught Off Guard

What Is a Call Feature?
New issues of bonds and other fixed-income instruments will pay a rate of interest that mirrors the current interest rate environment. If rates are low, then all the bonds and CDs issued during that period will pay a low rate as well. When rates are high, the same rule applies. However, issuers of fixed-income investments have learned that it can be a drain on their cash flow when they are required to continue paying a high interest rate after rates have gone back down. Therefore, they often include a call feature in their issues that provides them a means of refunding a long-term issue early if rates decline sharply. Many short-term issues are callable as well.

For example, a corporation that issues a 30-year note paying 4% may incorporate a call feature into the bond that allows the corporation to redeem it after a predetermined period of time, such as after five years. This way, the corporation won't have to keep paying 4% to its bondholders if interest rates drop to 1 to 3% after the issue is sold. Corporations will also sometimes use the proceeds from a stock offering to retire bond debt.

SEE: Managing Interest Rate Risk

Getting Called
Bondholders will receive a notice from the issuer informing them of the call, followed by the return of their principal. In some cases, issuers soften the loss of income from the call by calling the issue at a premium, such as $105. This would mean that all bondholders would receive a 5% premium above par ($1,000 per bond) in addition to the principal, as a consolation for the call. Because call features are considered a disadvantage to the investor, callable bonds with longer maturities usually pay a rate at least a quarter point higher than comparable non-callable issues. Call features can be found in corporate, municipal and government issues as well as CDs. Preferred stocks can also contain call provisions.

Investor Options
Investors who receive call notices on their bonds are left with the dilemma of what to do with their money after their principal is refunded. Of course, they can leave their funds in cash, but most will seek to replace their called note with a similar investment, if possible. However, attractive alternatives will seldom be readily available for called bondholders because their bonds will generally be called only when rates are low.

Going Corporate
Investors have several options they can choose from if they don't want to stay in cash. A key issue to consider is the current interest rate environment. If rates are forecasted to stay low for the foreseeable future, then it may be wise to consider purchasing an intermediate-term bond that pays a higher rate than cash. Investing in a riskier bond, such as an investment-grade corporate bond, may be an alternative for investors who were called out of a municipal or agency offering and are willing to take a moderate amount of risk. Those who decide to purchase new bonds will probably be wise to wait for the next new issue rather than purchase them in the secondary market, as bond prices increase when interest rates are down.

Climbing the Bond Ladder
If the Fed is expected to raise rates several times within the next two years, then a structured ladder of short-term bonds or CDs may provide the best return possible until interest rates permit the replacement of the called instrument with a similar issue. A bond fund may also be a viable alternative for both conservative and aggressive investors, as these instruments can provide diversification and professional management.

SEE: Boost Bond Returns With Laddering

Widow and Orphan Stocks
Utility stocks and income-producing stocks of stable blue chip companies can also replace the income lost from a bond call. A conservative investor who is called out of a CD or agency issue might consider moving a portion of the principal refunded into a government or conservative corporate fund with a solid long-term track record, and then using the rest of the cash to purchase shares of a local utility company.

This provides balance and diversification without excessive risk. However, investors should be wary of scrambling to replace a high-yielding investment with the first thing that they find, just to preserve cash flow. A foray into junk bonds is not a wise substitute for a conservative investor who was called out of a CD or agency offering.

Put Options
These options are similar to call options, except that it is the investor who has the option to put the bond back to the issuer within a certain time frame, such as a 90-day window after five years. Put options provide investors with the same option that call options give issuers: a way to redeem the issue after a certain period of time. Investors would put an issue back to the issuer if rates have risen substantially since the time of issue. Then they can reinvest the money in higher-paying instruments. Of course, this option comes at a price - bonds with put options usually pay a slightly lower rate than bonds without.

The Bottom Line
Calls usually come at a very inconvenient time for investors. Those who get their principal handed back to them should think carefully and assess where interest rates are going before reinvesting. A rising rate environment will likely dictate a different strategy than a stagnant one. Investors with put options must likewise evaluate their alternatives when their put option becomes effective.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  2. Investing Basics

    What's a Treasury Note?

    A treasury note is a U.S. government debt security that offers a fixed interest rate and a maturity date that ranges between one and 10 years.
  3. Investing Basics

    What is a Settlement Date?

    A settlement date is the day a security trade must be settled.
  4. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  5. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  6. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  7. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  8. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  10. Mutual Funds & ETFs

    ETF Analysis: Guggenheim BulletShrs 2018 HY CorpBd

    Find out about the Guggenheim BulletShares 2018 High Yield Corporate Bond ETF, and get information about this ETF that focuses on high-yield corporate bonds.
RELATED TERMS
  1. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. Security

    A financial instrument that represents an ownership position ...
  4. Series 6

    A securities license entitling the holder to register as a limited ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
RELATED FAQS
  1. Why do zero coupon bonds tend to be volatile?

    Zero coupon bonds are volatile because they do not pay any periodic interest during the life of the bond. Upon maturity, ... Read Full Answer >>
  2. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  3. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  4. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  5. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>
  6. How do I use the holding period return yield to evaluate my bond portfolio?

    The holding period return yield formula can be used to compare the yields of different bonds in your portfolio over a given ... Read Full Answer >>

You May Also Like

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!