Callable Bonds: What are they and what are their risks and returns?

Posted by The Dopkins Wealth Team | Oct 30, 2014 12:37:09 PM

Q: What are callable bonds? And what are the risk and return of callable bonds?municipal-bond

A: Callable bonds are fixed income securities that give the issuer the right, but not the obligation, to call in, or prepay, the bond prior to maturity. Issuers can be expected to exercise this right if they are able to reissue new debt at lower interest rates, once all costs of a recall and new issuance are considered.

The presence of the call feature greatly affects the risks and potential rewards of owning a bond. The failure to understand this risk creates the potential for large losses and investors being abused by broker-dealers. Most municipal and agency bonds, as well as some corporate bonds, have a feature that gives the issuer the right, but not the obligation, to prepay the principal (prior to maturity) on a specific date or dates. This call feature creates significant risk to investors, for which they do receive a higher yield as compensation. The higher yield creates the potential for great returns but also, depending on the price paid for the bond, the potential for underperformance because the issuer will only call the bond if interest rates have fallen significantly since the time of issuance (rates need to have fallen sufficiently to overcome the cost of a new issue to replace the original one).

When an investor purchases a bond with a call feature, the incremental yield slightly shortens the bond’s duration. As a result, if rates rise, the value of the callable bond will not fall quite as much. But in accepting this benefit, the investor is also accepting the risk that, should interest rates fall significantly, the bond likely will be called by the issuer (assuming the issuer has maintained its credit worthiness). Because of the higher incremental yield, many broker-dealers tend to build portfolios with longer-maturity bonds that contain short call features. Longer-term bonds typically have higher markups, so this strategy allows brokers to charge higher markups in the hope that the bonds will get called, giving them the opportunity to mark up another bond. This strategy can have negative consequences to investor when interest rates rise because the duration of the portfolio could rise dramatically, adding more volatility. The same is true if rates fall because this is when bonds will typically be called, leaving the client to invest in a low-interest-rate environment.

Bottom line: When analyzing whether a callable bond is an appropriate investment, the investor should consider whether the higher yield is sufficient compensation for the risk that falling rates will lead to early redemption of the bond. It’s also important to keep in mind that the call feature is there to benefit the issuer and not the investor.

We prefer to build ladders with either non-callable bonds or bonds with at least 80 percent call protection. This approach provides more “control” over when the funds come due as well as the duration, allowing the ladder to stay intact. Contact a Dopkins Wealth investment advisor about your individual situation and goals.


Copyright © 2014, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.


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Topics: fixed income, bonds, municipal bonds, muni bonds, investing in bonds, investment strategy

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The Dopkins Wealth Team Dopkins Wealth Management (DWM) is an investment advisory and consulting firm that specializes in providing comprehensive wealth management services by incorporating tax planning, business succession planning, wealth preservation, and wealth transfer into our investment strategies and fiduciary-based solutions. Whether it’s an individual, institutional investor, Corporate 401k plan, foundation or endowment, our clients benefit from our use of an investment strategy grounded in academic research that focuses on long-term success. The key to our client’s success is our ability to understand their unique financial goals and needs, and integrate that with their need, ability, and willingness to take risk to formulate a long-term plan for financial security and prosperity. For more information, contact Tom Emmerling at

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