Last month's decline in the ten-year Treasury yield to 3.93% was self-limiting, because the drop ensures that the economic recovery will persist. Treasuries have been on a wild ride this year: yields melted to deeply overvalued levels (3.07%) this past June when deflation fears erupted, then suffered a record-breaking sell-off into August (4.66%) when the economy improved. The Fed's determination to get the economy on a solid growth path ensures that the monetary aggregates will remain positive until after gains in gross domestic product (GDP) are firmly positive for several months. An increase in the Fed Funds rate is not imminent until we see a decisive upturn in payroll growth. This is unlikely until sometime in 2004.
Looking ahead, we expect positive economic news and, later on, a less dovish Fed to spur higher yields. The building enthusiasm for equities, a weak dollar and huge new issues of Treasury securities needed to finance a growing fiscal deficit are further reasons we expect rates to rise. According to our bond models, we expect to see another increase in ten-year Treasury yields near 5.3%. But, right now, investment yields on fixed income securities are near historic lows.
Assuming that you are maintaining a certain portion of your portfolio in fixed income, where do you reinvest the money from your called bonds and preferred stocks? First, do not be tempted to load up on stocks. Stick with your long-term asset allocation. Bonds have served investors very well ever since the stock market began to crumble in 2000. Market timing should be left to those investors who can afford to lose money. Income and safety are still available to conservative investors and you do not need to settle for the very low returns offered by bank certificates and money market mutual funds.
Look for bonds that are likely to be called within a year. These will be priced on a yield-to-call basis which is higher than regular bank CD rates. One lesser-known security that aptly fills this need is callable CDs issued by various banks.
The Callable CD Strategy
Several banks have recently issued a growing number of securities with many different "callable" structures. A callable Certificate of Deposit(CD) is one that may be redeemed at Par, prior to its original stated maturity, at the option of the issuer. For investors interested in fixed income investments, this surge of callable issuance provides an opportunity to invest in a product that carries a higher initial coupon than would be available in non-callable securities of comparable credit quality.
What is a "Call Provision"?
A common feature in most fixed income securities is a call provision. This feature gives the issuer the right to redeem the bond or preferred stock ahead of the stated maturity date of that issue. Even if the security has a twenty year or longer maturity, the right to call an issue early may begin only a few years after the issue date and it may even include a premium of 1% or 2% over the face value. A corporation may exercise such a provision for a variety of reasons, but most likely is that it can reissue new securities at lower net cost. This decision is analogous to deciding to refinance a home mortgage.
Calls mean that you are being handed back your money at a time when you will have to reinvest at lower rates of return. For some investors, calls can be disruptive because they upset a laddered portfolio which may need to be rebalanced. For professional money managers, calls disrupt target bond portfolio duration metrics.
The past couple of years have been the best refinancing environment corporations have seen in the last decade. Hence, investors have to reexamine their portfolios because the bonds and preferred stocks that were purchased years ago at higher rates are the very ones most likely to be called at the earliest opportunity. If the coupon on your security is 1% or more above that available today on those of comparable credit quality, a call is likely.
Why do these premier issuers want to issue callable debt?
Callable securities provide the issuer with greater flexibility in managing their balance sheet. Once an initial non-callable period has passed, the issuer can call the debt according to the terms of the particular security's call provision. This means that if interest rates decline, the issuer can replace the securities with less expensive liabilities.
What are the benefits of Callable CDs?
Callable Certificates of Deposit are issued with a wide variety of stated final maturities, typically 5-20 years, allowing investors to choose the CD that best fits their investment objectives. Callable CDs are covered by federal deposit insurance provided by either the Bank Insurance Fund or Savings Association Insurance Fund, in each case administered by the Federal Deposit Insurance Corporation (FDIC) and backed by the full faith and credit of the United States Government, to the maximum amount permitted by law (currently $100,000).
Callable CDs may be redeemed early at the full principal value in the event of the death or adjudication of incompetency of the owner. Callable CDs are available in minimum denominations of $10,000 and increments of $1,000 thereafter. This may vary somewhat depending on availability.
Who invests in Callable CDs?
Due to the yield, recognized credit quality, and the variety of maturities available, Callable CDs appeal to many different investor groups. Buyers of callable securities include individuals, pension funds, insurance companies, commercial banks, credit unions, savings banks and other financial institutions.
Why are the interest rates and Annual Percentage Yields so much higher than traditional fixed rate Certificates of Deposit? The investor has, in effect, sold the right to call the CD prior to maturity to the issuer. This call feature has considerable value. Thus, the financial institution pays the investor a higher interest rate than they would receive purchasing a non-callable CD in exchange for receiving this right to call the issue.
What causes a Callable CD to be Called?
A Callable CD may be called when the issuer determines that it is cheaper to issue a new security than it is to pay the interest payments on the outstanding security. There is no simple way to predict precisely when a call will occur. However, when interest rates decline by 1% or more, the probability that the investment will be called increases significantly.
What structures are available in Callable CDs? Which one is right for me?
FIXED RATE - On a Fixed Rate Callable CD, the interest rate is set and remains constant until maturity or the call date. This is considered the simplest type of Callable CD structure.
STEP UP - On a Step Up CD, the interest rate increases over time on a predetermined schedule until maturity or until the CD is called. This structure might be appealing to investors who think interest rates may rise in the future.
STEP RATE - On a Step Rate CD, the initial interest rate is slightly above market for a specified time period and then declines and remains fixed until maturity or until the CD is called. This CD might appeal to an investor most concerned with current income or who thinks that interest rates may decline.
ZERO COUPON (ZCDs) - ZCDs are Zero Coupon deposit instruments that are sold at a discount from their final maturity value. Interest income is compounded while an issue is outstanding and received as part of the eventual redemption price. This type of CD might appeal to investors who don't need current income, for example an IRA, Pension or Keogh account.
Is there a secondary market?
An active secondary market exists for Callable CDs. It should be recognized, however, that the relatively small deal size of the issues and their unique characteristics place limitations on the potential liquidity of the product. Therefore they are best suited for "buy and hold" investors as there is little likelihood that the securities will ever trade at a significant premium over their redemption value. Accordingly, if these investments are sold in the secondary market prior to maturity or call date, they may be worth less than their original cost.
What if interest rates rise and the CD is not called?
If the CD is not called at the earliest call date, you get the full coupon yield for that much longer. As long as a call remains likely, they will trade close to the call price. Hence, you have some protection against price erosion due to further rate rises. Nonetheless, in a serious bear market for bonds, these issues could fall below par in price.
Why not just buy a bond fund?
Now may not be the best time to buy a bond fund. Bond funds have likely built up taxable capital gains this year. These will have to be distributed to all fund holders by December. This includes recent fund buyers who did not own shares while the gains were being accumulated.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.