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).