Understanding Callable Bonds

Understanding Callable Bonds

Bond with early repayment option

A callable bond is a bond containing a provision that allows the issuer to buy back the bond at a price greater than the bond's face value before the maturity date. The early repurchase is referred to as a call option and may occur when interest rates have fallen to such a level that the bond issuer could issue new debt at a lower rate of interest than the rate being paid on the outstanding bonds. The bond agreement specifies the terms under which the issuer can call the bond, the earliest date that the bond can be called (the first call date), and the price that must be paid to investors in order to exercise the call option (the call price).

Most corporate and agency bond issues contain a call provision

Most corporate bonds and agency bond issues contain a call provision, which provides the issuer with the flexibility to refinance debt in the event of an interest-rate drop.

Advantages

Offer generally higher yields than noncallable bonds.

Investors are generally paid a higher yield to compensate them for the potential loss of the fixed income stream in the event of a call.

Tradeoffs

Callable bonds are subject to refunding risk

Callable bonds present the bondholder with the uncertainty of the bond remaining outstanding until the maturity date.

Tax consequences

Earnings may be fully taxable

Depending on the specific type of bond, the interest payments you receive on your callable bond may be fully taxable at ordinary income tax rates at both the federal and state levels.

Preferred stock dividends may be taxed at a flat 15% (if qualified).

Capital gains are taxable

If you sell a bond at a profit before it matures, you will generate a capital gain. Gains on investments sold within one year of purchase are considered short term and taxed at your ordinary income tax rate. Gains on investments held longer than one year are considered long term and are subject to the lower capital gains tax rates.

Capital losses may be used to offset gains

If you sell a bond for less than you paid, you may incur a capital loss. However, capital losses can be used to offset capital gains on other investments. If your losses exceed your gains, you may be able to deduct net capital losses from your ordinary income. Capital losses exceeding a certain threshold (currently $3,000, $1,500 if married filing separately) may be carried forward and used to offset gains in future years.

Provided by courtesy of Daniel Roccato, MBA, CPM, Quaker Wealth Management, LLC, in Moorestown, N.J. Securities & Advisory Services offered through VSR Financial Services Inc., a Registered Investment Adviser and Member NASD/SIPC. Quaker Wealth Management is a separate entity from VSR Financial Services.