How a Callable Bond Worked

The Federal Farm Credit Banks (FFCB) bond I bought in February finally got called. For more info about federal agency/GSE bonds, see my previous post Agency Bonds for Higher Yield Over Treasury.

A callable bond means after a certain date, the bond issuer can redeem the bond early, before the bond’s stated maturity date. When the issuer exercises that option, the bond is “called.” It’s similar to refinancing a mortgage, only in this case I’m the lender while the bank is the borrower. It makes sense for them to call the bond because they can borrow money at a lower rate now. Actually I’m surprised they didn’t call it sooner. My 9-year 5.81% FFCB bond became callable after May 22, 2007. Since then, the 10-year Treasury yield went down from 4.8% to 4.0%. Yields on money market funds and online savings accounts also went down. Through this time, my bond was earning 5.81%, state income tax free, until it was called last week.

 

Was that FFCB bond a good deal then? Well, yes and no. For the 9-1/2 months I owned the bond, my principal was never really at risk. I earned more interest than I could earn from any other similar low risk investment. After all taxes are taken into consideration, the yield on the bond was higher than that on any money market fund, bank savings account, or CD. It was a good investment. However, when I bought that 9-year FFCB bond in February, I could’ve bought a 10-year 4.625% Treasury note instead. The price at that time was 99.09 for a yield of 4.74%. Today the price of this note has become 104.85. Although the Treasury note paid 1.2% p.a. less than the FFCB bond, its price has gone up by 5.8%, which more than makes up for the lower interest. So I could’ve done much better.

That’s how a callable bond works. If you buy a callable bond, you get a higher yield because you give the bond issuer an option to redeem the bond early. That option has value. That’s why they are willing to pay a higher interest rate. If the market yield goes down after you buy the bond, your bond may be called and you give up the upward price appreciation you would otherwise get from a call-protected bond. If the market yield remains level, you collect the extra interest as your compensation for giving the borrower the early redemption option. If the market yield goes up, you still collect the higher interest and you lose less to the price depreciation.

I haven’t decided what to do with the proceeds yet. I’m thinking of buying another callable agency bond like this 11-year FFCB bond paying 5.60%, callable after 3/11/2008. Because the interest rate has come down, there is less call risk now than earlier this year. Or I can add more money to my stock ETFs, either the Russell 2000 Value ETF (IWN) or the Vanguard REIT ETF (VNQ).

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Comments

  1. AGG says

    Thank you for the post. I’ve been reading your blog for a while, I like your way of thoughts. With regard to bonds at this time, many sources are suggseting to opt out of them due to the risk of rate fluctuation in the next year and sticking with money markets. Things like BND, or i-shares total bond did not do well recently. What do you think?

  2. Anonymous says

    I am puzzled by your choice of IWN. First, why not use Vanguard’s viper equivalent – they are much cheaper? Second, this ETF has 31% of its value in finance, since it is Russel 2000. Do you think it is the right time to get into things like IYF and other heavy-finance ETFs?

  3. TFB says

    Thank you for the comments and questions.

    @AGG: Bonds did fine this year. BND and AGG are both up ~6% in 2007. Vanguard Intermediate Treasury Fund and Inflation Protected Fund are both up 9%. If Fed keeps lowering interest rates, yield on money market funds will go down. The FFCB bond I’m considering pays 5.6%, state income tax free. Not bad in this environment in my opinion. The worst case is that I’m stuck with it for 11 years, collecting 5.6% a year. I’m comfortable with that. I’m not recommending it to everybody though, because 11 years is a long time.

    @Anon: Vanguard’s small value ETF ticker symbol VBR is cheaper by 0.12% a year. However IWN has 1/3 more stocks and 40% lower median market capitalization. When I buy a small cap fund/ETF, I like it small and more broadly diversified.

    VBR is also 30% in financials. I don’t speculate on sectors with an exception for REITs. So I don’t have any opinion on IYF.

  4. Jean Cigogne says

    Just reading through these old posts as I consider this callable agency bond strategy. It seems to me that if you could predict when a bond will be called, then you could adjust the maturity ladder accordingly (i.e., buy bonds that are more likely to be called early when interest rates are rising and bonds that are less likely when interest rates are declining.

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