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One of the most difficult risks for investors to
understand is that posed by ?call? and refunding provisions. If the bond?s
indenture (the legal document that spells out its terms and conditions)
contains a ?call? provision, the issuer retains the right to retire (that
is, redeem) the debt, fully or partially, before the scheduled maturity
date. For the issuer, the chief benefit of such a feature is that it permits
the issuer to replace outstanding debt with a lower-interest-cost new issue.
A call feature creates uncertainty as to whether the bond will remain
outstanding until its maturity date. Investors risk losing a bond paying a
higher rate of interest when rates have declined and issuers decide to call
in their bonds. When a bond is called, the investor must usually reinvest in
securities with lower yields. Calls also tend to limit the appreciation in a
bond?s price that could be expected when interest rates start to slip.
Because a call feature puts the investor at a disadvantage, callable bonds
carry higher yields than non callable bonds, but higher yield alone is often
not enough to induce investors to buy them. As further inducement, the
issuer often sets the call price (the price investors must be paid if their
bonds are called) higher than the principal (face) value of the issue. The
difference between the call price and principal is the call premium.
Generally, bondholders do have some protection against calls. An example
would be a bond that has a 15-year final maturity, non call two years. This
means the investor is protected from a call for two years, after which time
the issuer has the right to call the bonds.
Sinking-fund provisions
A sinking fund is money taken from a corporation?s earnings that is used to
redeem bonds periodically, before maturity, as specified in the indenture.
If a bond issue has a sinking-fund provision, a certain portion of the issue
must be retired each year. The bonds retired are usually selected by
lottery. One investor benefit of a sinking fund is that it lowers the risk
of default by reducing the amount of the corporation?s outstanding debt over
time. Another is that the fund provides price support to the issue,
particularly in a period of rising interest rates. However, the disadvantage
which usually weighs more heavily on investors? minds, especially in a
falling-rate environment is that bondholders may receive a sinking-fund call
at a price (often par) that may be lower than the current market price of
the bonds.
Other types of redemptions
Bond investors should be aware of the possibility of certain other kinds of
calls. Some bonds, especially utility securities, may be called under what
are known as Maintenance and Replacement fund provisions (which relate to
upgrading plant and equipment). Others may be called under Release and
Substitution clauses (which are designed to maintain the integrity of assets
pledged as collateral for some bonds) and Eminent Domain clauses (which have
to do with paying off bonds when a governmental body confiscates or
otherwise takes assets of the issuer). Ask about these and any other special
redemption provisions that may apply to bonds you are considering. You can
avoid the complications and uncertainties of calls altogether by buying only
non callable bonds without sinking-fund provisions. If you do buy a callable
bond and it is called, be aware that its actual yield will be different than
the yield to maturity you were quoted. So ask your Financial Consultant to
tell you what the yield to call is as well.
Puts
Just as some issuers have the right to call your bond prior to maturity,
there is a type of bond known as a put bond that is redeemable at your
option prior to maturity. At specified intervals, you may ?put? the bond
back to the issuer for full face value plus accrued interest. In exchange
for this privilege, you will have to accept a somewhat lower yield than a
comparable bond without a put feature would pay.
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