Callable and putable bonds

In short

A friend of mine once bought a bond that paid a handsome rate, then lost it to an early payoff just when rates fell. That is the heart of a callable bond. The issuer, which is the borrower, keeps the right to repay the bond before its due date, and it tends to use that right when it can borrow more cheaply. A putable bond works the other way around, because the holder, the person who owns the bond, may hand it back early for its face value. Both features change how much a bond pays and how long it lasts. Read the offering documents to see the call dates and the call price before you count on any yield. A bond that looks like it runs thirty years may be gone in five.

The whole of it

What it is

I once watched a neighbor refinance his house the week rates dropped, and he grinned like he had found money in an old coat. The company that issues a callable bond has that same option. A bond is a loan. You lend money, and the issuer promises interest plus your money back on a set date. A callable bond adds a clause that lets the issuer pay it off early, on dates and at a price named in advance. That price is often the face value plus a small extra amount, and the extra shrinks as the years pass.

A friend of mine who likes tidy things once said a putable bond is the callable bond's honest cousin. With a put, the power sits with the holder. On the dates the bond allows, the holder may sell it back to the issuer at the put price, which is usually face value. It works a bit like a return policy on a good pair of boots. The bond contract spells out the dates and the price.

Why would anyone sign such a deal? Because the right has a price. The issuer of a callable bond pays a higher rate to make up for the risk of early payoff. The issuer of a putable bond pays a lower rate, since the holder gets a safety net. You pay for protection one way or another.

How it works

If you are holding a callable bond, you have probably wondered when the call might come. Here is the plain story. Say rates drop after the bond is sold. The issuer can pay off the old bond and borrow again at the new, lower rate. That is good for the issuer and not so good for the holder, who must now reinvest the money at those lower rates. Bond people call that reinvestment risk, which just means the risk of having to start over at worse terms.

Many callable bonds come with call protection. That is a stretch of years at the start when the issuer cannot call the bond at all. A bond might have ten years to run with its first call date at year five. The contract names that date, and the indenture, the legal document behind the bond, holds the details.

Because of this, a callable bond has two yields worth knowing. The yield to maturity assumes the bond lasts until its final due date. The yield to call assumes the issuer pays it off on the first call date. The lower of the two is often called the yield to worst, and it is the honest one to plan around. It answers a simple question. What do I earn if things go the way that is worst for me?

A putable bond turns this around. If rates rise, the old bond pays less than new ones do. The holder can use the put to get face value back and buy something that pays more. That choice is why putable bonds usually pay a lower rate than similar bonds with no put.

The numbers, and where to find yours

Every figure you need sits in the bond's own paperwork. Look for the call schedule, which lists each call date and the price on that date. Look for the put dates and the put price if the bond is putable. Look for the coupon, which is the yearly interest rate, and the maturity date.

For bonds sold to the public in the United States, the issuer files an offering document with the Securities and Exchange Commission. You can search those filings on the SEC's EDGAR system. Municipal bonds post their official statements on the Municipal Securities Rulemaking Board's EMMA website. FINRA, the industry regulator, offers a bond search tool at its site as well. Your brokerage statement may show a call date too, but check it against the source.

If you own Treasury bonds, here is some news. Most Treasury bonds sold today cannot be called. Some older ones could be, and the Treasury's TreasuryDirect site explains what it offers now. Do not rely on rules from memory, so check the document for the exact bond.

One more number matters here, and it is set by law and not by the contract. Interest from most corporate bonds is taxable at your ordinary income rate, and the figures change from year to year. The IRS publishes the current brackets, so look at the current figure, which the official source publishes each year for the verified numbers and the date.

A worked example

A friend of mine, Dolores, once bought a bond for her small savings account, and I will tell it as it happened, with round numbers. Dolores paid $1,000 for a bond with a 6 percent coupon, so it paid $60 a year. The bond ran twenty years. It could be called after five years at $1,030.

Four years later, rates fell. New bonds from the same company paid only 4 percent. At year five, the company called the bond. Dolores got $1,030 back. Her total return looked like this. She earned $60 a year for five years, which is 5 times $60, or $300, and the call gave her $30 more than she paid. Her total gain was $300 plus $30, or $330 on her $1,000.

Now see what changed. She planned on twenty years at $60, which is 20 times $60, or $1,200 in interest. Instead she got $300. She also had $1,030 to put back to work at 4 percent, so the new money earned about $41.20 a year, since 4 percent of $1,030 is $41.20. Her yearly income fell from $60 to $41.20, a drop of $18.80. That gap is the cost of the call.

Had her bond been putable at $1,000, the story would run another way. If rates had climbed to 8 percent, she could have handed it back for $1,000 and bought a new bond paying $80 on each $1,000. That is $20 more each year than the $60 she had. The put paid her for the lower coupon she accepted at the start.

Where it goes wrong

I have noticed that people read the big yield on the front of a callable bond and stop there. That is the first trap. A high yield may be the yield to maturity, and the bond may never reach maturity. The yield to worst is the figure to check.

The second trap is price. A callable bond trading above face value is a puzzle. Suppose a bond costs $1,060 and the call price is $1,030. If the issuer calls it, the holder loses $30 of what was paid. Pay close attention to that.

A third trap is the quiet one. People assume a call only happens when it hurts. It does tend to happen when rates fall, which is just when the holder wants to keep the old bond. Calls can also come when the issuer has extra cash or wants to clean up its debt. The contract controls this, so read it.

With puts, the trouble is different. A put is only as good as the issuer's ability to pay. If the company is in trouble, the put may be worth little, because the borrower has to have the cash to buy the bond back. A promise from a weak borrower is still a weak promise.

Questions to answer before you leave this page

When is the first call date on the bond you hold, and what price will the issuer pay on that day? What is the yield to worst, and have you looked at it next to the yield to maturity? If the bond is called next year, where would you put the money, and what would that new investment pay? Does the bond come with call protection, and for how many years? If the bond is putable, which dates allow the put, and what price does the contract name? Can the issuer afford to buy it back if many holders ask at once? And have you found the offering document on EDGAR or EMMA, so the facts come from the source and not from a guess?