Monday, July 23, 2007

Callable Bonds: More Interesting Things Learned

As I have previously mentioned, a callable bond is one that the issuer can redeem (force you to sell) at a particular price, on or after a particular date. For example, a bond might have a maturity of November, 2037, but when issued, the bond specifies that it can be called at 100 (par value) on November 1, 2009. Sometimes the call price is above par; often it is at par. And as I discussed before, there is the even more mysterious "Make Whole Call" provision on some bonds.

Well, I am starting to look at long-term bonds, partly because I've got a bit of money sitting in a money market fund that wants a better return, and partly because I think we may be near or at the top of interest rates for a while. I noticed that some of the callable bonds have very high yields. There's a reason for this, and it is important to understand this if you are buying bonds. For example, there is a Federal National Mortgage Association (Fannie Mae) bond that matures 6/22/2037, with a 6.75% coupon (CUSIP 31398ADR0). The current price is 100.10--just above par. The yield to maturity is 6.742%; the yield to worst (meaning if they call the bond at the worst possible price and date) is 6.689%. The bond can be called as early as 6/22/2009 at a price of 100.0.

So why does a government agency bond (which is almost as safe as a Treasury bond) pay such a high yield? Because Fannie Mae bonds are financing homes. If someone pays off their Fannie Mae mortgage (by refinancing or by sale) early, as often happens, Fannie Mae may end up calling the associated bond. If so, you get the par value of the bond back, and you have enjoyed this very high interest rate for several years.

It is possible that this Fannie Mae bond will not be called before it matures in 2037, but I would not bet on it. Remember that if interest rates come plummeting down, people with mortgages that are financed by this bond will have a strong incentive to refinance their homes, or in the inevitable housing frenzy, they will sell their current home, and pay off the loan. If interest rates go up, it creates an incentive for home owners to keep their current mortgage.

Think of these high yield, low risk, but callable bonds as paying a pretty hefty premium for the high probability that they will be called when interest rates have fallen substantially--and you then have to find a better place to park your money while waiting for interest rates to rise again.

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