It used to be simpler. Or at least it seemed that way when I was a kid. When I was a kid, my parents would talk about stocks and bonds and certificates of deposits. Admittedly, I did not pay much attention. I was more interesting in playing with my friends, fishing, camping, playing sports, and music. But occasionally I did overhear them talking about investments and the following is what I understood as a 10 something year old.
Stocks were something that companies sold you to raise money. In return you got a stake in their company. Stocks were risky because they were tied to the success of the company and changed in value a lot. If the company did well, one could make a lot of money; if they did poorly, one could lose a lot of money if not all of it.
Bonds were something governments sold you to fund projects. In return you got a guaranteed rate of return. But the catch, with bonds and CD’s, was you could not get your money back for, like forever, which means 10 or 20 years or argh! 30 years.I know, not exactly correct but hey, I did say I did not pay much attention. Bonds were safer than stocks because they paid you a set amount of interest over a certain amount of time.
CD’s where what banks sold you to keep your money longer and in return, you got a little more interest. Again, for years at a time.
As I got older I learned a little bit more. Eventually I learned enough to do most of my investing on my own instead of relying on mutual funds run by other people. I have never claimed to be an expert and every now and then I learn something completely new.
Like the other day when my in-laws asked me about callable bonds.
The only time I have ever paid any remote interest in bonds and CD’s is with my 401K. Even then it is in the form of a managed fund which gets a monthly allocation (about 30%) from my salary every month. It’s one of many things in my life that is a set it and forget it type of plan.
To this day I try to apply the KISS principles to almost everything I do, including investing. Things are complicated enough without me trying to come up with new inventive ways of handling important things like money.
So when my in-laws called to complain that some of their bonds were being called early and wanted to know if it was even legal, I did not have an immediate answer for them. I actually learned two new things from that one question. Bonds can be callable just like options, and, some can even be called early.
How does this even work?
First let me try and explain a callable bond. The ten year old in me would say something like this:
Long-term bonds can have maturities of 10, 20 or even 30 years. Issuers sell callable bonds to avoid being locked into paying above-market interest rates if market rates fall after a bond is issued. For the investor, this makes a callable bond a riskier investment than a non-callable bond. Suppose a company sells a bond with an 8 percent interest rate and a 30-year maturity. Five years later, market interest rates are down to 6 percent. With non-callable bonds, the issuer is stuck with paying 8 percent while the bondholder — that’s you — can fly high by collecting above-market interest. If bonds are callable, though, the issuer can exercise the call option, pay off the high interest bonds and issues new bonds at the lower market rate. That means that you, the investor, lose out just when you should be benefiting from the fruits of your investing genius.
Because investors take a greater risk by purchasing callable bonds, they usually get higher yields to compensate. This means that the bond pays a higher interest rate if it is callable than if it is non-callable. If interest rates on two bonds are the same, the callable bond usually has a lower market price than the non-callable bond, which boosts its effective interest rate.
This much makes sense. What I could not understand at first, nor my in-laws, is how the issuer could call them back early before the call date. In this case I learned that this is a clause in the contract that states it is subject to a pre-refund. The issuer has the option to call the bond before the call date, usually with an additional premium.
But the end result is the same. The issuer will call the bond and want to re-issue at a much lower rate.
So naturally the next question from my in-laws was what should we do? Right now the rates on bonds, and CD’s for that matter, are not nearly as good as they were many years ago. They are looking at a substantial decrease in income at todays rates. My initial reaction is that perhaps they should consider either a broadly diversified bond fund or a fixed rate bond or CD that is not callable.
One option which presented itself was an investment plan which laddered bonds or CD’s over a series of years. This method would have them investing 20% of their money every year in shorter term (say 5 year) bonds or CD’s. The net affect would re-invest every five years but on a yearly cycle.
Here is how a CD ladder would work:
Investing 5 equal amounts into 1 to 5 years for example 50,000 would be invested:
10,000 one year maturity
10,000 two year
10,000 three year
10,000 four year
10,000 five year
When the one year matures, you buy a new 5 year because the 5 year is reduced to a 4 year.
Such a plan would require a bit more planning and perhaps more fees. The ten year old in me still believes in the KISS principle and would probably recommend the broader diversified bond fund or a fixed rate. But the laddering approach is interesting especially if you think rates will go up.
The important thing for my in-laws, and anybody else who is looking to buy bonds, is to decide what fits their investment style best, consider all the options regarding rates, term lengths, fees, and most definitely read and understand all the fine print of any contract.
As I researched the myriad of information on the internet regarding callable bonds; including but not limited to, pre-refund, renewable bonds, one-time vs continuous call option dates, call steps, reset preferred as well as all the other investment strategies such as layered vs laddered I definitely began to wonder what I and my in-laws had gotten into.
It can be quite daunting to investors when confronted with all the options out there. That is one main reason I try to keep things and simple as possible.
I’d like to thank Rico over at Smart Money who deftly explained all this in a way that even the 10 year old inside my head could understand.