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Question:
I've heard from some sources that buying callables rather than bullets is not a good plan. They say that from a total return perspective, the bullet will yield more. But if I buy a three-year callable and the yield to call (YTC) and yield to maturity (YTM) are both higher than a bullet agency with the same maturity, and I never plan to sell the bond, then who really cares about total return?
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Answer:
Callable debt securities have a built-in call option that gives the issuing entity the right to redeem the security prior to its stated maturity. Typically three types of call options can be embedded in the security; American, Bermuda, and European style options. An American call option can be exercised at any time after the first stated call date. A Bermuda call option may be called only on the scheduled call dates. And a European callable security is callable only on the specified exercise date. If the call does not occur, the bond then becomes a “bullet” security for the remainder of the term and cannot be called thereafter. Investors receive a higher yield than they would on comparable non-callable securities for these options.
Total return is based upon the coupon received, a horizon date, and a projected market value. Total return can be calculated on the basis of subjected forecasts of the reinvestment rate and required yield at the end of the investment horizon. Or investors can use scenario analysis by specifying different possible values for the reinvestment rate and the required yield at the end of a given investment horizon, the total return associated with each scenario is then calculated. When computing total returns based on scenario analyses investors should be aware that total return estimates will only reflect expected investment returns. In other words, projected total return is based on the market’s or investor’s expectations and only comes to fruition if end-of-period yields turn out to be correct. You don’t have to sell the security, because the unrealized gain or loss is factored into the calculation.
Simply stated, if a callable with a European option is purchased and the call option is not exercised, your actual total return is higher than the bullet, for you received a higher yield for the option that was never exercised. In actuality, if rates move up rapidly and remain high, the total return of callables exceeds that of bullets irrespective of the type of call. The reason is fairly simple; you received a higher coupon for the same maturity. If interest rates decline and the security is called away, a lower interest rate is earned on the principal returned and reinvested after the call date; therefore you have a lower total return than a bullet security.
From an ALM perspective, current callables always model better in the up scenarios and have less price volatility than equal maturity bullets. Reason being that as rates rise, the call option falls “out of the money” and therefore is not worth as much as the original purchase. As the premium of the call dwindles, the spread compresses. As an example, if the spread compresses 20 basis points (bps) given an up 200 bps scenario, the price volatility is equal to a 180 bps movement of a bullet with the same coupon and maturity. The price loss is less and the total return is greater.
Since rates are currently so low, my bet is that the return on callables (especially those with longer call options) will exceed that of bullets. In other words, chances of rates rising next year are probably higher than rates falling. Although we are not a great fan of callable securities, we are increasing our recommended allocation to a targeted 15 to 30 percent of the aggregate portfolio, which is up from less than 10 percent. One reason is that rates are most likely at their trough. Another is that premiums of mortgages are high, but that’s another topic for another day.
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