Use of Callable Bonds in a Cash Flow Matched Portfolio

We recently got a question from one of our client’s consultants regarding the use of Callable Bonds in our cash flow matched bond portfolio. The consultant seemed surprised that we would include them in the universe of acceptable investment-grade bonds to use in an immunized portfolio.  Here is the answer from our head of trading that we provided.

“These day’s it is very difficult to find Corporate bonds that do not have a call feature.  The majority of them have call provisions.  The calls are most often “Make-Whole” call provisions. 

A makewhole call provision is a call provision attached to a bond, whereby the borrower must make a payment to the lender in an amount equal to the net present value of the coupon payments that the lender will forgo if the borrower pays the bonds off early.

The call provisions usually can be exercised until three months before the bond’s maturity date.

Although we do not have much choice these days, buying callable bonds is actually a good strategy when one thinks interest rates will stay relatively stable to maybe going down a little too possibly going up.

This is because an investor receives extra yield at the time of purchase over and above the yield on a non-callable bond plus the investor will receive a premium or prepayment penalty when the bond is called due to the Make-Whole call provision. 

The extra yield from a callable bond acts as a cushion if interest rates rise.   

If interest rates stay flat or go sideways no-harm-no-foul because the investor just reinvests into a new bond at about the same yield that he started with plus the investor received the extra yield at purchase plus the premium at the time of the call.  This means a pickup in income over a non-call bond.

If interest rates go down a little say 25 to 50 basis points then the extra yield received upfront at purchase plus the premium at the time of the call will offset some of the loss in yield due to having to reinvest into a lower-yielding bond.

Finally, the Liability Beta Portfolio cash flow matching strategy is 100% focused on income and not total return.  It is true that a non-callable bond will have better total return performance in a declining interest-rate environment but only if one sells the bond before maturity.  And then if an investor sold her non-call bond before maturity to collect a price gain she would effectively be imposing a self-call because then she would have to reinvest into that lower interest rate environment the same as a callable bond investor would.”

 

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