What is a “callable bond” and why would anyone choose to invest in one?
The concept is pretty straightforward. While a tradition bond, such as most US Treasury Bonds, promises to pay you the stated interest rate until the maturity date, one that is “callable” is a bit more complex. A callable bond can be redeemed by the issuer prior to its maturity. In other words, if it suits the issuer, the bargain can be terminated early and you get your money back.
Sometimes the return of principal includes a premium (extra money) to compensate for the fact that the redemption isn’t so great for the bond holder. Sometimes it does not. That depends on the terms of the bond – which are the equivalent of a long and complex legal contract.
The primary reason such a bond is redeemed before its final maturity date is that interest rates have fallen. In such a situation, the issuer would be able to refinance the debt more favorably. The market price of the bond would almost surely have risen. And, of course, you as bond holder are going to get your money back at a moment when only lower interest rates are available if you wish to reinvest on similar terns.
Thus, a callable or “redeemable” bond is structured so that the issuer has a choice as to whether to end the deal and give bond holders their money back at certain points in time. Bond holders, of course, are not offered this flexibility. It is not a fair or even deal. That should be OK, though, since the price of the bond is adjusted to reflect that this provision is a one-sided covenant in the issuer’s favor.
A properly functioning and highly liquid marketplace [Link to: http://negotiatingtruth.com/functioning-market] will price these bonds correctly to adjust for this one-sided provision. But what if the marketplace for bonds is either not functioning properly or not highly liquid?
As is typical in the financial world, this complexity in the structure and fairness of the bond is going to benefit the party who has more information. If both sides of the transaction are highly sophisticated bond experts, the whole thing is going to turn out fine. That, however, is not the reality of the world we live in. And it is certainly not the reality of this voracious industry. Rather, the information asymmetry will probably be used to take advantage of the party less able to protect its own interests in this deal. And that, dear reader, is going to be you.
At a conference I recently attended, a speaker was taking about bond market trading. In the middle of a discussion about deals between highly sophisticated institutional traders, someone asked a question about individual bond investors. The expert paused briefly and said, “Retail investors get slaughtered in the bond market.” No explanation, no concern, and no further comment. He just offered it as a widely known and indisputable fact. Then he went back to what he had been talking about.
It’s true, small retail investors get slaughtered in the bond market. They are playing on a field which they don’t belong on. Like a kitten on a superhighway. For unlike large capitalization US stocks, bonds are not traded in a properly functioning liquid market. Rather, small bond investors must rely on bond desks concerned with their own inventories, mark-ups, and profitability. The small investor must contend with complexity, opaqueness, rent-seeking, and asymmetric information that all work against her.
The simple answer is to avoid callable bonds entirely. There are plenty of good alternatives. You can stick to bonds that are more straightforward. Even better, you can delegate the entire problem to a low cost mutual fund or ETF. Perhaps better still is to invest in an index fund that eliminates entirely the question of which bond is better than another.
Having completely sidestepped the problem, all you need is a succinct answer as to why. When a friend, neighbor or bond salesman asks you why you decline to invest in these bonds, your reply will be simple. “When the game is ‘heads they win, tails I lose,’ I prefer not to play.”