Callable step-up bonds may not be a household name, but the companies and government agencies that issue them are. General Electric, Xerox, and Fannie Mae are but a few recent issuers.
These fancy-sounding products are the most popular form of what Wall Street calls structured notes, which are bonds loaded with bells and whistles. Callable step-ups are high-quality bonds with an above-market interest rate, a call feature, and a coupon that increases annually over the life of the bond. It's because the bonds are complex that they promise higher interest rates--and more risk--than simpler, noncallable securities.
RATE VICTIMS. Sounds enticing, especially for investors looking to lock in some profits from the overheated stock market and get some fixed-income exposure. Indeed, the bonds are once again gaining in popularity after an industry shakeout in 1994. At that time, these bonds were structured much more aggressively. While they were designed to perform extremely well when interest rates were low, they had a dramatic downside when interest rates rose. Some were set up so that if interest rates increased past a certain point, bondholders would get no return at all. Of course, interest rates surged in 1994, and these bonds lost their appeal. Today, callable step-up bonds, which are actually derivatives sold by stockbrokers in denominations as little as $1,000, are designed to be much more balanced across varied interest-rate environments, so demand is picking up. The $2.2 billion in callable step-up notes issued so far this year is more than the $2.1 billion issued in all of 1995, according to Securities Data.
Still, like most Wall Street-engineered products, there are hidden risks which often make these fixed-income instruments a bad buy--especially if you must have access to your principal at a set time in the future.
First, it is important to understand how callable step-up coupon notes work. Take, for example, a recent Freddie Mac issue, sold at par with a 10-year final maturity in 2006 and initial interest rate of 7%. It is callable after one year and any time beyond that with 10 days' notice. If Freddie Mac decides to call the bond after a year, then the investor will have earned a 7% return, vs. the 5.58% yield on a one-year Treasury bought at the time of Freddie Mac's issue. If Freddie Mac chooses not to call the bond, then the yield increases to 7.10% in 1997 and rises incrementally each year, until it reaches 9% the last year before maturity. If the bond is held until maturity, it will give an average yield that is approximately 100 basis points above that of a 10-year Treasury note. Noncallable 10-year Freddie Mac paper currently yields only 30 basis points more than Treasuries.
The trickiest part of these bonds is the call option. Investors often are sold callable step-up notes as short-term fixed-income products with the assumption that they will be retired after the first year. The sales pitch compares the first-year yield with that of a one-year Treasury. In general, when interest rates are stable or falling, these bonds are called after the first year. It makes sense: If the coupon is going to increase more than the interest rate, it is best for the issuer to call the bond. So it's unlikely the investor ever will reap the highest advertised yields.
But that's only half the story. If interest rates rise sharply, what was sold as a one-year bond could easily be held until final maturity, be it 5, 10, or 15 years. And as with any long-term fixed-income product, the risk of rising interest rates means a potential for capital loss.
INEFFICIENT MARKET. So the big problem with these securities is that they force buyers to commit to the investment for a specific term while the issuer has the option to back out at any time. That leaves investors without any way to fully analyze the risk of complex call options. While it's possible to sell the bonds before they are called, investors will more than likely lose money, since they would probably get less than par for them. That's in part because these bonds trade in a relatively inefficient market.
What's more, during periods of declining interest rates, callable bonds won't appreciate in value as much as noncallable notes because potential buyers fear the bonds will be called, and nobody will pay a premium for them, says Sanford Bragg, managing director of Standard & Poor's managed-funds ratings department. The result: minimal price appreciation.
So, if there's even the slightest chance you'll need your investment anytime soon, skip the seductive sales pitch and the promise of higher yields for noncallables. Keep it simple, and buy a Treasury security or short-term bond fund to park your cash or profits from the stock market.