Another Called Bond
I mentioned a while back that some of my Fannie Mae bonds had been called--meaning redeemed for their full face value. It has happened again, with some Federal Home Loan Bank Board bonds. These had a 5.7% coupon, and since I bought them a little under par (meaning, for a bit less than their face value), I enjoyed more than 5.7% annualized yield for several years.
I would love to know exactly what is happening with all these called bonds. If they are being called because homeowners are selling their houses, that's a positive sign for the economy. If they are being called because homeowners are refinancing their houses at lower interest rates, that's good for the homeowners. It may be good for the economy if the extra money in their pockets every month gets spent buying goods in depressed parts of the economy.
I need to accelerate my rate of bond buying--to call what you get from money market funds a "yield" is a bit misleading: it's more like surrender!
UPDATE: That's odd. There is suddenly a dearth of government agency bonds with decent yields--the best that I can find are some Fannie Maes maturing in 2029, with a yield to worst of 5.040%. Perhaps that's because the markets haven't opened.
UPDATE 2: Yes, there are some Fannie Maes now with 5.7% annualized yields to worst now.
Showing posts with label becoming wealthy. Show all posts
Showing posts with label becoming wealthy. Show all posts
Wednesday, October 7, 2009
Thursday, September 17, 2009
Bonds
Bonds
I'm looking at somewhere to invest money from the called Fannie Mae bonds, and I am actually disturbed by how high the yields are on not just government agency bonds, but even corporate bonds.
Why am I disturbed? Because a high yield on a bond usually indicates one of three things:
1. There's a non-trivial risk of default.
2. The economy is booming, and interest rates have been driven up by this.
3. There is a high risk of long-term inflation.
Well, we know that #2 isn't true. The economy is not booming. It may recover in the next year or two--indeed, I think that is likely--but it isn't booming right now. Both #1 and #3 are pretty worrisome possibilities.
If we were talking about junk corporate bonds, then #1 wouldn't be concerning. But these are AAA-rated 30 year corporate bonds with average yields of 5.36%. The government agency bonds? Those are averaging 5.51%. If there is a non-trivial risk of the U.S. government defaulting, then you are probably better off investing in cases of 7.62mm NATO and canned food. And Nancy Pelosi (D-Babylon) talking about political violence isn't helping alleviate my concerns.
That's such a scary thought that I have to want to believe that #3 is the real problem: the risk of high inflation, and not just for a few years. Inflation is fine for people that have no assets, and lots of debt--until the inflationary spiral makes their jobs go away. But unless you can find an investment that gets ahead of price inflation, anyone who has any assets at all is going to be in a world of hurt. I'm sure that George Soros and other billionaires leftists have figured out how to profit nicely from this disaster. The rest of us have much to worry about.
Now, if there were a functional Republican Party made up of responsible adults, there might be some hope of both taking both control of Congress and fixing the problems. But I'm afraid that all we can realistically hope for is the first part of that: taking back control of Congress. The corruption of the Republican Party 2002-2006 is unlikely to be corrected just because they kick out the clowns currently up there.
I understand why my ancestors immigrated to Plymouth and Boston in the 1620s and 1630s. The England that they lived in was too depraved a place in which to raise a family. If there were spaceships going off planet right now, I would be sorely tempted.
I'm looking at somewhere to invest money from the called Fannie Mae bonds, and I am actually disturbed by how high the yields are on not just government agency bonds, but even corporate bonds.
Why am I disturbed? Because a high yield on a bond usually indicates one of three things:
1. There's a non-trivial risk of default.
2. The economy is booming, and interest rates have been driven up by this.
3. There is a high risk of long-term inflation.
Well, we know that #2 isn't true. The economy is not booming. It may recover in the next year or two--indeed, I think that is likely--but it isn't booming right now. Both #1 and #3 are pretty worrisome possibilities.
If we were talking about junk corporate bonds, then #1 wouldn't be concerning. But these are AAA-rated 30 year corporate bonds with average yields of 5.36%. The government agency bonds? Those are averaging 5.51%. If there is a non-trivial risk of the U.S. government defaulting, then you are probably better off investing in cases of 7.62mm NATO and canned food. And Nancy Pelosi (D-Babylon) talking about political violence isn't helping alleviate my concerns.
That's such a scary thought that I have to want to believe that #3 is the real problem: the risk of high inflation, and not just for a few years. Inflation is fine for people that have no assets, and lots of debt--until the inflationary spiral makes their jobs go away. But unless you can find an investment that gets ahead of price inflation, anyone who has any assets at all is going to be in a world of hurt. I'm sure that George Soros and other billionaires leftists have figured out how to profit nicely from this disaster. The rest of us have much to worry about.
Now, if there were a functional Republican Party made up of responsible adults, there might be some hope of both taking both control of Congress and fixing the problems. But I'm afraid that all we can realistically hope for is the first part of that: taking back control of Congress. The corruption of the Republican Party 2002-2006 is unlikely to be corrected just because they kick out the clowns currently up there.
I understand why my ancestors immigrated to Plymouth and Boston in the 1620s and 1630s. The England that they lived in was too depraved a place in which to raise a family. If there were spaceships going off planet right now, I would be sorely tempted.
Sunday, September 13, 2009
Called Bond
Called Bond
This is disappointing, but not entirely surprising. I bought some Fannie Mae bonds several years ago that had 6.75% annual yield--and they weren't scheduled to mature until 2037. They were callable bonds (meaning that Fannie Mae had the option of buying back the bonds at the full face value before maturity), which is why they paid such a high interest rate. And today I received notice from Schwab that Fannie Mae is indeed doing exactly that.
I actually paid slightly less than face value for the bonds, so I did very nicely with these bonds--6.75% interest on a very safe bond for several years, and now I get my original money back--but now I have to find somewhere to invest that money that gets a decent return.
This is disappointing, but not entirely surprising. I bought some Fannie Mae bonds several years ago that had 6.75% annual yield--and they weren't scheduled to mature until 2037. They were callable bonds (meaning that Fannie Mae had the option of buying back the bonds at the full face value before maturity), which is why they paid such a high interest rate. And today I received notice from Schwab that Fannie Mae is indeed doing exactly that.
I actually paid slightly less than face value for the bonds, so I did very nicely with these bonds--6.75% interest on a very safe bond for several years, and now I get my original money back--but now I have to find somewhere to invest that money that gets a decent return.
Saturday, February 7, 2009
The First Time Homebuyers Tax Credit
The First Time Homebuyers Tax Credit
I'm helping my daughter and son-in-law with their taxes, and as a result, I have had some occasion to look at this new "first time homebuyers tax credit." It looks like a good deal, but it isn't, in any conventional sense, a tax credit. A more accurate description is that the government is making you a 0% loan of $7500 to buy a house--even though you pretty much needed a down payment to buy a house. They aren't fronting you the money, so it's a loan only for loose definitions of "future" and "past."
It turns out that unless you have a pretty high income (or a very average income in California or New York City), if you and your spouse or partner haven't owned a house in the last three years, and you buy one, you will get $7500 back on your federal tax return--even if your total tax liability is zero! For many people who bought a first house in 2008 (especially those with incomes below $40,000), the combination of interest payments and property taxes means that they have little or no federal tax liability anyway, so they get most or all of their federal withholding back--plus $7500.
So why isn't this a refundable tax credit in the conventional sense? Because it is actually a loan. If you sell the house, you have to repay the $7500 in the applicable tax year. If you don't sell the house, after two years, you have to start paying the $7500 back, over a 15 year period. So if you take the tax credit on your 2008 tax return, when you file your 2010 tax return, your taxes will include a $500 payment, and so on until the $7500 is repaid, or you sell the house.
This is potentially quite dangerous if you scraped together the down payment to get into the house, get this $7500 windfall, and decide that you need a small scale Sony Jumbotron for the house--and then, a couple years down the road, you suddenly have to sell the house. Now you need that $7500 to repay the government when you file your tax return for the year that includes the house sale.
On the other hand, if you put that $7500 into a bunch of $500 CDs, and pay back the $500 every year with one of those CDs, you are perfectly safe. You've got the money to pay back the 0% loan; you are earning interest on it over those 15 years; and if you sell the house in the meantime, even if you don't make any money on it, you still have the money in CDs with which to pay back Uncle Sam. You will actually come out ahead.
If there weren't so many people who have done stupid things involving houses (and 401k funds) over the last few years, or if you could be sure that once you have bought a house, you would not be moving out of the area suddenly, I wouldn't worry too much about this program. But I have a weird feeling that a more than a few people are going to fill in the paperwork, get the $7500 windfall, and spend it in ways that will make drunken sailors look responsible--and there's going to be a nasty fall, several years down the road.
As I mentioned at the start, this is phrased by the IRS as a form of loan to first time homebuyers. But normally you can't buy a house without money in hand. You can't borrow it from family or friends, and you can't cash advance your credit card to get the down payment. If family provides the funds, it has to be a gift, or it is no good. So what is this talk about being a loan to help first time homebuyers? It almost looks like the government is encouraging people to lie about receiving a gift from relatives for the down payment, and then, after they have moved in, using this "refundable tax credit" to pay back the "gift" to relatives.
But what the heck, the whole last several years of subprime mortgage insanity has been an elaborate piece of deception and chaos. Why not add some more to the mess?
I'm helping my daughter and son-in-law with their taxes, and as a result, I have had some occasion to look at this new "first time homebuyers tax credit." It looks like a good deal, but it isn't, in any conventional sense, a tax credit. A more accurate description is that the government is making you a 0% loan of $7500 to buy a house--even though you pretty much needed a down payment to buy a house. They aren't fronting you the money, so it's a loan only for loose definitions of "future" and "past."
It turns out that unless you have a pretty high income (or a very average income in California or New York City), if you and your spouse or partner haven't owned a house in the last three years, and you buy one, you will get $7500 back on your federal tax return--even if your total tax liability is zero! For many people who bought a first house in 2008 (especially those with incomes below $40,000), the combination of interest payments and property taxes means that they have little or no federal tax liability anyway, so they get most or all of their federal withholding back--plus $7500.
So why isn't this a refundable tax credit in the conventional sense? Because it is actually a loan. If you sell the house, you have to repay the $7500 in the applicable tax year. If you don't sell the house, after two years, you have to start paying the $7500 back, over a 15 year period. So if you take the tax credit on your 2008 tax return, when you file your 2010 tax return, your taxes will include a $500 payment, and so on until the $7500 is repaid, or you sell the house.
This is potentially quite dangerous if you scraped together the down payment to get into the house, get this $7500 windfall, and decide that you need a small scale Sony Jumbotron for the house--and then, a couple years down the road, you suddenly have to sell the house. Now you need that $7500 to repay the government when you file your tax return for the year that includes the house sale.
On the other hand, if you put that $7500 into a bunch of $500 CDs, and pay back the $500 every year with one of those CDs, you are perfectly safe. You've got the money to pay back the 0% loan; you are earning interest on it over those 15 years; and if you sell the house in the meantime, even if you don't make any money on it, you still have the money in CDs with which to pay back Uncle Sam. You will actually come out ahead.
If there weren't so many people who have done stupid things involving houses (and 401k funds) over the last few years, or if you could be sure that once you have bought a house, you would not be moving out of the area suddenly, I wouldn't worry too much about this program. But I have a weird feeling that a more than a few people are going to fill in the paperwork, get the $7500 windfall, and spend it in ways that will make drunken sailors look responsible--and there's going to be a nasty fall, several years down the road.
As I mentioned at the start, this is phrased by the IRS as a form of loan to first time homebuyers. But normally you can't buy a house without money in hand. You can't borrow it from family or friends, and you can't cash advance your credit card to get the down payment. If family provides the funds, it has to be a gift, or it is no good. So what is this talk about being a loan to help first time homebuyers? It almost looks like the government is encouraging people to lie about receiving a gift from relatives for the down payment, and then, after they have moved in, using this "refundable tax credit" to pay back the "gift" to relatives.
But what the heck, the whole last several years of subprime mortgage insanity has been an elaborate piece of deception and chaos. Why not add some more to the mess?
Friday, February 6, 2009
Health Savings Accounts
Health Savings Accounts
I've been looking into setting up an HSA because I am having to pay for my own health insurance now, and it might be attractive to get an health insurance plan with a high deductible in exchange for lower premium payments. When looking for information about this, I discovered something rather interesting: you can move money from an IRA into an HSA without suffering this withdrawal of money from the IRA as a taxable event--so you don't pay income tax on the withdrawal, or the 10% early withdrawal penalty. There are, of course, gobs of details and limitations written in mind-numbing gobbledygook, but this is still quite useful, since I have some money coming out of an HP retirement plan (not my 401k) that is going into an IRA that I figured would just sit there for another eight years--but this might be a useful way to put some of that money to work paying for deductibles.
HSAs ordinarily can't be used to pay for health insurance premiums--with two exceptions, one of which is currently quite useful to me:
I've been looking into setting up an HSA because I am having to pay for my own health insurance now, and it might be attractive to get an health insurance plan with a high deductible in exchange for lower premium payments. When looking for information about this, I discovered something rather interesting: you can move money from an IRA into an HSA without suffering this withdrawal of money from the IRA as a taxable event--so you don't pay income tax on the withdrawal, or the 10% early withdrawal penalty. There are, of course, gobs of details and limitations written in mind-numbing gobbledygook, but this is still quite useful, since I have some money coming out of an HP retirement plan (not my 401k) that is going into an IRA that I figured would just sit there for another eight years--but this might be a useful way to put some of that money to work paying for deductibles.
HSAs ordinarily can't be used to pay for health insurance premiums--with two exceptions, one of which is currently quite useful to me:
Can I pay my health insurance premiums with an HSA?
You can only use your HSA to pay health insurance premiums if you are collecting Federal or State unemployment benefits, or you have COBRA continuation coverage through a former employer.
Saturday, January 10, 2009
When Borrowing Is A Good Thing (Part 2)
When Borrowing Is A Good Thing (Part 2)
I posted recently my analysis of the pay cash vs. borrow for buying the Jaguar, and received a couple of interesting responses from readers. One reader thought it made more sense to spend $5000 to $8000 (cash) to buy a used Subaru, rather than a Jaguar. The problem is that a $5000 to $8000 used Subaru around here means at least 80,000 miles or more--enough that the Subaru is well out of warranty, and realistically, you can expect at least a few substantial repairs on a car that age. The Jaguar is still under factory warranty, and will be for a couple of years. That alone is a strong case for the Jaguar.
The more substantial criticism of my analysis is that I was ignoring the income stream that I would enjoy from paying cash for the car, and putting those car payments that I am making into savings every month. I had completely overlooked that. It does change the equation a bit, but not quite as dramatically as you might assume.
What doesn't change: there is still a net $2738.94 interest income from the 4.30% APY CD (after paying federal and state income tax on the interest at a marginal rate of 33%). The total interest paid over 60 months on the car loan is $2458.23. But what interest would the $335.97 per month payment accrue over those 60 months?
Remember that the 4.30% APY CD was because I locked that interest in during November--and I would not get that interest rate today--and the way things are going, not likely again for another year or more. Also, that rate required me to lock it in for five years. While some of the early car payments could be locked in for five years, and get a roughly similar situation, the vast majority of those payments would be in the second, third, fourth, and fifth years. Unless I was locking up that money for five years (which is not a comparable situation), I would never get 4.30% APY--not even close. Furthermore, my credit union has a minimum $500 balance to get CD rates that high, so at least every other month I would just have the money sitting in a demand deposit account, at a much lower rate.
If I managed to earn 3% a year on the money that would otherwise be going to car payments (which seems extremely unlikely, with current interest rates), I would only have a net interest income of $1029.11 over five years--and I would be forgoing the $2738.94 net interest income that the $17,700 would have earned in the CD.
So, if I keep the money in a CD, and make payments: $2738.94 CD income - $2458.23 car loan interest = $280.71 net income. If I had paid cash, and broken a couple of CDs: $1029.11 net interest income (and that is making the optimistic assumption of 3% yield) - $2738.94 lost CD income, for a net loss of $1709.83. Even with a completely unrealistic 6% yield as I put those "car payments" into savings, this still comes to a net loss of $611.38 over five years.
So, what about the supposed rule that you should never make payments, if you can afford to pay cash? If there is a big difference in interest rates between CDs and loans, this might be true. Under some economic conditions, this might be true. If you don't have a spectacular credit score (my FICO number is 819), you may get stuck with such a high interest rate that you would be better off paying cash. But my guess is that many people that can afford to pay cash for a car probably also have a pretty decent credit score. (Okay, drug dealers might be the exception.)
I am adding the spreadsheet for modeling this here. This should apply to any loan where the interest is not tax deductible. Houses and student loans require different treatment--I may work on that as I feel more energetic.
I have updated my discussion of How To Become Wealthy with this at the very end.
UPDATE: One reader noticed a slight formula error; I made appropriate adjustments.
I posted recently my analysis of the pay cash vs. borrow for buying the Jaguar, and received a couple of interesting responses from readers. One reader thought it made more sense to spend $5000 to $8000 (cash) to buy a used Subaru, rather than a Jaguar. The problem is that a $5000 to $8000 used Subaru around here means at least 80,000 miles or more--enough that the Subaru is well out of warranty, and realistically, you can expect at least a few substantial repairs on a car that age. The Jaguar is still under factory warranty, and will be for a couple of years. That alone is a strong case for the Jaguar.
The more substantial criticism of my analysis is that I was ignoring the income stream that I would enjoy from paying cash for the car, and putting those car payments that I am making into savings every month. I had completely overlooked that. It does change the equation a bit, but not quite as dramatically as you might assume.
What doesn't change: there is still a net $2738.94 interest income from the 4.30% APY CD (after paying federal and state income tax on the interest at a marginal rate of 33%). The total interest paid over 60 months on the car loan is $2458.23. But what interest would the $335.97 per month payment accrue over those 60 months?
Remember that the 4.30% APY CD was because I locked that interest in during November--and I would not get that interest rate today--and the way things are going, not likely again for another year or more. Also, that rate required me to lock it in for five years. While some of the early car payments could be locked in for five years, and get a roughly similar situation, the vast majority of those payments would be in the second, third, fourth, and fifth years. Unless I was locking up that money for five years (which is not a comparable situation), I would never get 4.30% APY--not even close. Furthermore, my credit union has a minimum $500 balance to get CD rates that high, so at least every other month I would just have the money sitting in a demand deposit account, at a much lower rate.
If I managed to earn 3% a year on the money that would otherwise be going to car payments (which seems extremely unlikely, with current interest rates), I would only have a net interest income of $1029.11 over five years--and I would be forgoing the $2738.94 net interest income that the $17,700 would have earned in the CD.
So, if I keep the money in a CD, and make payments: $2738.94 CD income - $2458.23 car loan interest = $280.71 net income. If I had paid cash, and broken a couple of CDs: $1029.11 net interest income (and that is making the optimistic assumption of 3% yield) - $2738.94 lost CD income, for a net loss of $1709.83. Even with a completely unrealistic 6% yield as I put those "car payments" into savings, this still comes to a net loss of $611.38 over five years.
So, what about the supposed rule that you should never make payments, if you can afford to pay cash? If there is a big difference in interest rates between CDs and loans, this might be true. Under some economic conditions, this might be true. If you don't have a spectacular credit score (my FICO number is 819), you may get stuck with such a high interest rate that you would be better off paying cash. But my guess is that many people that can afford to pay cash for a car probably also have a pretty decent credit score. (Okay, drug dealers might be the exception.)
I am adding the spreadsheet for modeling this here. This should apply to any loan where the interest is not tax deductible. Houses and student loans require different treatment--I may work on that as I feel more energetic.
I have updated my discussion of How To Become Wealthy with this at the very end.
UPDATE: One reader noticed a slight formula error; I made appropriate adjustments.
Wednesday, January 7, 2009
When Borrowing Is A Good Thing
When Borrowing Is A Good Thing
It is conventional wisdom that borrowing to buy when you can afford to pay cash is a mistake. It is often a mistake, but not always. When I bought the Jaguar, I was reluctant to put the cash out of pocket, figuring that it might be useful to have the cash available as the economy sinks deeper and deeper.
For example, I was able to get 4.30% APY Certificates of Deposit in late November. The first year, the CDs for the $17,700 (roughly) that I would have paid for the car, title, and sales tax, would earn $761.10 in interest. Assuming a marginal federal and state income tax rate of 33% (because it may be a while before I get a permanent job again), that's a net of $509.94 of interest income. Over five years, the net income from the $17,700 in principal comes to $2700.89.
Over the five year life of the loan, my 5.24% car loan will cost me $2370.59 in total interest. That means that it actually saves me $330.30 over the life of the loan.
UPDATE: See a more detailed analysis here.
It is conventional wisdom that borrowing to buy when you can afford to pay cash is a mistake. It is often a mistake, but not always. When I bought the Jaguar, I was reluctant to put the cash out of pocket, figuring that it might be useful to have the cash available as the economy sinks deeper and deeper.
For example, I was able to get 4.30% APY Certificates of Deposit in late November. The first year, the CDs for the $17,700 (roughly) that I would have paid for the car, title, and sales tax, would earn $761.10 in interest. Assuming a marginal federal and state income tax rate of 33% (because it may be a while before I get a permanent job again), that's a net of $509.94 of interest income. Over five years, the net income from the $17,700 in principal comes to $2700.89.
Over the five year life of the loan, my 5.24% car loan will cost me $2370.59 in total interest. That means that it actually saves me $330.30 over the life of the loan.
UPDATE: See a more detailed analysis here.
Thursday, July 26, 2007
Not As Stupid As I Look
I bought about $100K worth of callable Fannie Mae bonds yesterday morning, with an average annualized yield to worst of about 6.6%. And today?
The other hint is that I am seeing a lot of car companies offering zero percent loans. These are usually relatively short duration (two to three years), but often this shows that automobile demand is down and the car companies expect interest rates to be low enough over the next few years that they can afford to make these zero percent loans, because it isn't going to cost them much to finance cars at these low rates.
I just wish that I had been really smart, and bought another $100K worth of bonds at the same time!
I bought about $100K worth of callable Fannie Mae bonds yesterday morning, with an average annualized yield to worst of about 6.6%. And today?
NEW YORK (CNNMoney.com) -- Bonds rose sharply Thursday as homebuilders reported weak earnings and a durable orders report came in lower than expected.My reason was that I saw a lot of hints that in spite of the Fed's nervousness about inflation, the economy is running out of steam. Actually, the housing part of the economy is running out of steam, while other parts did not seem to be--but that durable orders report indicates that other parts of the economy are beginning to follow. (No surprise: a lot of the durable goods purchased ended up going into new houses, or getting purchased with home equity loans--which is stupid.)
The 10-year jumped 25/32, or $7.81 on a $1,000 note, to yield 4.80 percent, down from 4.90 percent Wednesday. The 30-year bond climbed 1-3/32, or $10.94 on a $1,000 note, to yield 4.95 percent, down from 5.02 percent. Bond prices and yields move in opposite directions.
The 5-year gained 21/32 to yield 4.62 percent. While the 2-year rose 9/32 to yield 4.57 percent.
The other hint is that I am seeing a lot of car companies offering zero percent loans. These are usually relatively short duration (two to three years), but often this shows that automobile demand is down and the car companies expect interest rates to be low enough over the next few years that they can afford to make these zero percent loans, because it isn't going to cost them much to finance cars at these low rates.
I just wish that I had been really smart, and bought another $100K worth of bonds at the same time!
Tuesday, July 24, 2007
Bonds For Those Prepared to Take Moderate Risks
Bonds that are S&P rated at BBB and above are considered "investment grade" while below BBB they are considered "junk bonds." What this means is that the risk of default is substantially higher. In exchange for the risk, you get much better returns.
As an example of an S&P BBB rated bond, CUSIP 577778CB7, May Dept. Stores, is a bond due 7/15/2024, with a 6.65% coupon--and the current price is 88.083. This means that the yield to maturity is 7.94%. This is a "Make Whole Call" bond, so there is a possibility that it could be called (at a price of 100) before the bond matures--and that, along with the risk, is why the yield is so spectacular.
I would not encourage anyone to invest a big chunk of the portfolio in a bond like this--but if you have some very, very safe bonds that are paying 6%, putting a small portion of your bond portfolio in something like this might be a prudent way to improve the average return.
Bonds that are S&P rated at BBB and above are considered "investment grade" while below BBB they are considered "junk bonds." What this means is that the risk of default is substantially higher. In exchange for the risk, you get much better returns.
As an example of an S&P BBB rated bond, CUSIP 577778CB7, May Dept. Stores, is a bond due 7/15/2024, with a 6.65% coupon--and the current price is 88.083. This means that the yield to maturity is 7.94%. This is a "Make Whole Call" bond, so there is a possibility that it could be called (at a price of 100) before the bond matures--and that, along with the risk, is why the yield is so spectacular.
I would not encourage anyone to invest a big chunk of the portfolio in a bond like this--but if you have some very, very safe bonds that are paying 6%, putting a small portion of your bond portfolio in something like this might be a prudent way to improve the average return.
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.
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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