We are going to introduce you to another concept that you need to be aware of before buying a municipal bond. Many municipal bonds are callable, which simply means that the issuer can redeem the bonds earlier than the maturity date (i.e. pay back the bonds). Whether a bond is callable or not will be clearly stated along with the bond’s other details.
The call date or call dates will be specific. This means that the bond issuer can only exercise their option of redeeming the bonds early on certain dates.
Here’s an example:
In this example, these AAA-rated Georgia State General Obligation bonds pay a coupon of 5% and mature in 2024. Furthermore, the bonds are offered at a price of 118.08 with a yield-to-maturity of 3.306%.
What’s worth noting however is that Georgia has the right to call the bonds early on August 1, 2017, seven years prior to the maturity date.
If the bonds are called, your return will not be the yield-to-maturity of 3.306%, but your yield will be the yield-to-call of 1.92%. You will not know whether the bonds are going to be called or not until it’s close to the call date. When you buy a bond that is callable, you are assuming call risk; this is the risk that bonds are called early.
As a result, whenever a bond is callable, you will be shown both the yield-to-maturity and yield-to-call. The lower of the two is also known as the yield-to-worst or YTW; this means what your yield will be in the worst-case scenario (other than default).
In our example bond, the yield-to-call of 1.92% is dramatically lower than the yield-to-maturity of 3.306%. Why is this?
To buy $10,000 of these bonds at a price of 118.08 will cost you $11,808 + accrued interest. (Remember to think of price as $1.1808 and multiply by 10,000.)
Until either August 1, 2017 or August 1, 2024, you will be collecting interest payments of 5%, which is the coupon.
|February 2012||August 2012||$500|
|February 2013||August 2013||$500|
|February 2014||August 2014||$500|
|February 2015||August 2015||$500|
|February 2016||August 2016||$500|
|February 2017||August 2017||$500|
Total of interest payments is $3,250
If the bonds are called on August 1, 2017, you will get $10,000 back. You would have collected $3,250 in interest payments for a total of $13,250.
Remember, you paid $11,808 when you bought the bonds, but you will be getting back $10,000 on either the call date of 2017 or the maturity date of 2024. If the bonds are not called, you get to collect $500 per year for 7 more years until 2024, when you will get your $10,000 back.
This means that the $1,808 premium ($11,808 minus $10,000) you paid above the face value of the bonds will either be “lost” or spread over 6 years or 13 years.
This is known as amortization of premium. The concept is that when you pay more than the face value for bonds, the premium gets “spread over” or amortized over the years until you get your money back.
The longer it takes for the premium to be amortized, the better it is in terms of yield. Every year, you are basically “losing” a portion of the premium you originally paid for the bonds in exchange for a higher annual interest payment. For instance, in a simplistic sense, if the bonds get called in 6 years, you are “losing” $1,808 over 6 years, but collecting $500 in annual interest. If the bonds get called over 13 years, you are “losing” $1,808 over 13 years, but collecting $500 in annual interest throughout this period. Since the amount of yearly amortization is much lower when it is spread over 13 years, this results in a higher yield. This is why the yield-to-maturity in this case is higher than the yield-to-call.
Conversely, when a bond is trading at a discount or below face value, the opposite happens. If the same Georgia bonds were priced at 95, you would have paid $9,500 for the bonds. At the maturity date or on the call date, you will get back $10,000. If the bonds trade at a discount, the yield-to-call will be higher than the yield-to-maturity. If the bond is called early, you are “gaining” the $500 back over 6 years rather than waiting for the full 13 years. This is known as accretion of discount.
Most bonds over 10 years in maturity are going to be callable. The reason that bonds are callable is that issuers want the flexibility to pay back bonds early in the event that interest rates are lower at the time of the call date.
Think of callable bonds this way: It is like a person’s option to refinance their home when interest rates are lower. When a homeowner usually does this, they are paying back the original mortgage and getting a new mortgage with a cheaper rate. When an issuer calls bonds early, they are looking to take advantage of lower rates. This is usually good for the borrower and not good for the lender.
If you want to know exactly what you will be getting and when, callable bonds are not going to give you the certainty of having your money returned on one particular date. The option of when to pay you back is with the issuer.
In addition, the issuer is only going to call the bonds when interest rates are lower than the coupon on the bonds. They will pay you back early if the issuer can borrow cheaper than what they are paying you. This means when you get your money back, you will likely be investing at lower rates than the coupon rate on the called bonds.
Imagine if the bonds are called in 2017. Will you be able to reinvest $10,000 at that time for 7 years (to mature in 2024) with a yield of 5%? This is what you would need to do to equal the return of the original bond if it were not called.
If the issuer does not call the bonds in 2017, this probably means that interest rates on bonds with similar maturities are higher than the interest that they are paying you. This means that the issuer would likely have to pay new bondholders more than they are paying you. As a result, the issuer will not call the bonds.
If you are considering municipal bonds, you will run across callable bonds all the time. You should have a reasonable understanding of how callable bonds work and how your returns can be impacted. A good rule is to only buy callable bonds if both the yield-to-call and yield-to-maturity are attractive to you and if you would be indifferent as to whether the bonds are called early or not.
If you do not fully understand callable bonds and call features, simply avoid callable bonds. If you do avoid callable bonds, you will have a tough time finding municipal bonds with maturities beyond 10 years. There is no shame in only investing in things you fully understand.