Callable Securities

A callable municipal, corporate, federal agency or government security gives the issuer of the bond the right to redeem it at predetermined prices at specified times prior to maturity. Take, for example, a U.S. agency 10-year note noncallable for 3 years, maturing in 10 years, which can be “called” or redeemed by the agency issuer at the end of the third year after issuance—known as a “10nc3.” The three-year noncallable period is known as the “lockout” period.

Yields on callable bonds tend to be higher than yields on noncallable, “bullet maturity” bonds because the investor must be rewarded for taking the risk the issuer will call the bond if interest rates decline, forcing the investor to reinvest the proceeds at lower yields.

With a callable security, the investor’s compensation for selling the option is reflected in a higher yield and lower price as compared to a similar bullet security with the same maturity. In an example from 1997, A U.S. agency 10nc3 was offered at a yield of 6.856 percent while a 10-year bullet with the same coupon carried a yield of 6.236 percent. The difference in dollar price between these two securities would represent the value of the call option.

The investor has to determine the value of the option and the level of compensation required for the associated risks in a callable security.

The type of embedded option in a callable security affects the option’s value.

• American options are continuously callable at any time after the lockout period expires.
• Bermudian options give the issuer the right to call the bond on specified dates after the lockout period that typically coincide with coupon dates.
• European options have a one-time call feature coinciding with the expiration of the lockout period.¹

Coupled with the time to maturity, the lockout period also affects the option’s value. For example, the embedded option in a 10-year noncallable for six months (10nc6M) can be likened to a 6-month European option on a 9.5-year security. The embedded option in a 10nc3 European callable is the same as a 3-year option on a 7-year security. The uncertainty or risk associated with 7-year rates three years from now is higher than the uncertainty of 9.5 year rates 6 months from now, so the first option should have a higher value.

Prices on callable bonds depend on the market’s expectation of interest rates at the time the call feature on a bond becomes active in relation to the coupon rate on the callable bond. If the market expects interest rates at the time the option becomes active to be such that the issuer will exercise its option and call the bond, the option is said to be “in the money,” which can cause the security to trade at a premium to par, or a price higher than the bond’s face value. Discount callables, priced below face value, or par, with a coupon below the going market rate, have embedded options that are “out of the money.” This means that the market expects interest rates at the time the bond becomes callable will be such that the issuer will not exercise its option.

Premium callables trade at “yield to call”—meaning that the price of the bond is calculated with the assumption that the bond will be called—and carry extension risk. If interest rates rise before the end of the lockout period, the bond’s embedded option becomes worth less, as the security is less likely to be called. Discount callables trade like bullets—non-callable bonds—to maturity and carry compression risk. If interest rates fall, they become more likely to be called. Callable securities that are at the money—where interest rates are very close to the point where the option will be exercised—have the most sensitivity to changes in market rates and implied volatility.

Unlike a noncallable bond, a callable security’s duration, or sensitivity to interest rate changes, decreases when rates fall and increases when rates rise. The spread or difference in yield over comparable noncallable securities compensates callable investors for this “negative convexity.”

In addition to interest rate risk, the value of the options embedded in callables is sensitive to changes in the slope of the yield curve.² The value of the options is a function of forward rates,³ which are dependent on the spot4 level of rates and spot yield spreads.5

Volatility risk in callables takes two forms. The first is realized volatility: large swings in rates can necessitate frequent rehedging, with its associated costs, as well as underperformance. Implied volatility, or the market forecast of future rate uncertainty, is the second. When a position is unwound or sold, the value of the callable security will depend on the new level of implied volatility. If implied volatility is higher, callable security prices will be depressed.

Many investors use callable securities within a total return strategy—with a focus on capital gains as well as income—as opposed to a buy and hold strategy focused on income and preservation of principal.

Owners of callable securities are expressing the implicit view that yields will remain relatively stable, enabling the investor to capture the yield spread over noncallable securities of similar duration. They must also have views on the likely range of rates over the investment period and the market’s perception of future rate uncertainty at the horizon date for reasons explained in Risks of Investing in Callable Securities above. If an investor has the view that rates may well be volatile in either direction over the near term but are likely to remain in a definable range over the next year, an investment in callable securities can significantly enhance returns.

Premium callables would generally be used when the bullish investor believes that rates are unlikely to fall very far. Discount callables would generally be chosen when the investor believes volatility will be low but prefers more protection in an environment of rising interest rates.

1. Note that the names used to describe the types of options do not necessarily relate to where securities with these features are sold or traded.
2. The yield curve is the collection of interest rates at a variety of maturities. In most cases, the longer the maturity on a bond, the higher its yield. A steeply sloped yield curve indicates a relatively big difference between yields on bonds with shorter and longer maturities.
3. Forward rates are the market’s projection about the level of interest rates at some point in the future.
4. “Spot rates” refers to the current level of interest rates.
5. Yield spreads in this case refers to the difference between the interest rates of bonds of two different maturities, or two points on the yield curve.