Why An Early Call Needn't Disturb Your SleepJoan Warner
Many investors who depend on the double-digit interest from bonds they bought 5 to 10 years ago got a nasty shock recently when issuers called the bonds before maturity to refinance their debt at lower rates. Now, chastened yield-seekers know they should study the fine print in every bond prospectus for call provisions that can cut their income.
An early call isn't always bad news, however. In fact, callable bonds can yield handsome returns. That's because what you earn on a bond depends not only on its coupon but on the capital gain or loss you realize when you sell. Callable bonds are usually cheaper than comparable-quality noncallables. And issuers often pay bondholders a premium when they call their securities.
Take a 20-year, $1,000 bond paying 10.5% that you bought at its $1,000 face value in 1989 and is callable in 1994. To compensate you somewhat for your income loss, the issuer will buy the bond back at, say, $1,050 (in bondspeak, it's quoted as 105). In addition to your $105 annual interest payments, you will have earned $10 a year in capital gain, for an effective yield of 11%.
This year, the market may value your bond even higher than the call price, since its 10.5% rate stands out in the current environment. If your bond is trading at $1,100, you'll get a 13.8% yield by selling now, not subtracting taxes or commissions.
For investors not already holding high-coupon bonds, some bonds callable in the next couple of years can be excellent short-term plays, says Thomas Steffanci, director of fixed income at Fidelity Investments. Say you buy the bond described above now, at its premium of 110. When the bond is called in 1994 at 105, your two years of 10.5% interest will offset your capital loss, for a total return of 7.2%. "The idea is that over two years, you'll not only do better than the money market, but better than you would with bonds trading at par," says Steffanci. Why? Newly issued investment-grade (S&P A or better) two-year bonds are yielding about 6%, and two-year Treasuries pay 5%.
Patricia Zlotin, executive vice-president at Massachusetts Financial Services, advises investors to stick to bonds callable in the next two years. Further out, it's more likely that interest rates will rise, depressing your bonds' market value and making an early call less probable.
TWO ATTRACTIVE CALLABLES GTE 10 3/4 coupon, matures Sept. 15, 2017, callable Sept. 15, 1997, at 105.3, now trading at 115. Your yield to call is 7.8%,* compared with 6.5% for five-year Treasuries. OCCIDENTAL PETROLEUM 10 7/8 coupon, matures Mar. 1, 1996, callable Mar. 1, 1993, at par, now trading at 105. Your yield to call is 5.6%,* compared with 5% for one-year Treasuries. *Yields will be higher if you reinvest your interest. DATA: MASSACHUSETTS FINANCIAL SERVICES INC.