Callable bonds behave differently depending on the interest rate environment. While the Fed funds rate is expected to stay low in 2010 and possibly into 2011, understanding the characteristics and consequences of investing in a callable bond is fundamental to the management of a credit union’s investment portfolio.
In plain language, a callable bond is a bond that provides the issuer the option to redeem (retire) the issue before the final maturity date. A main determinant as to whether a bond is called is the level of existing interest rates. If interest rates have declined since the issue date, issuers will likely want to refinance the debt at a lower rate of interest.
The presence of a call option embedded in a bond presents two key traits to the bondholder:
Reinvestment Risk: Callable bonds open bondholders to reinvestment risk, since the issuer will call a bond when the yield on the bond in the market is lower than the bond’s coupon rate. Reinvestment risk is defined as the risk that future income will have to be reinvested at a potentially lower interest rate.
Price Compression: The price increase potential for a callable bond in a declining interest rate environment is limited because the market will progressively expect the bond to be redeemed at the call price as interest rates fall.
In a callable security, a call option could mean “negative” convexity. Convexity is the relationship between bond prices and bond yields that displays how duration of the bond changes as interest rates change. Convexity can be used to "shock" an investment or to measure the market risk of a portfolio of bonds. The following graph shows the price/yield relationship for a callable versus a non-callable bond.
As the graph shows, a bullet bond will experience price appreciation in a falling rate environment, whereas the callable instrument’s price appreciation could be limited due to the call provision. In this example, using a total return framework that incorporates both the coupon payments and the price of the bond, the bullet bond outperforms the callable instrument. In order to apply this universally, indicative information about the call feature, such as lock out periods, would need to be incorporated.
Because callable bonds act uniquely in different interest rate environments, it is important to understand the projected result of an investment in a portfolio, especially in uncertain market environments. Trust for Credit Unions’ Fixed Income University Series is hosting its third complimentary event, Explaining Convexity and Callable Bonds, next Tuesday, May 4, at 11:30 a.m. EST. Join in for background slides, the seminar, and a question-and-answer session. Sign up for the event here: www.trustcu.com/education.
The Trust for Credit Unions (TCU) is a family of institutional mutual funds offered exclusively to credit unions. Callahan Financial Services is a wholly-owned subsidiary of Callahan & Associate and is the distributor of the TCU mutual funds. Goldman Sachs & Co is the advisor of the TCU mutual funds. To obtain a prospectus which contains detailed fund information including investment policies, risk considerations, charges and expenses, call Callahan Financial Services, Inc. at 800-DIAL-TCU. Please read the prospectus carefully before investing or sending money. Units of the Trust portfolios are not endorsed by, insured by, obligations of, or otherwise supported by the U.S. Government, the NCUSIF, the NCUA or any other governmental agency. An investment in the portfolios involves risk including possible loss of principal.