Focus on Call Provisions

If a security’s yield is too good to believe, it’s probably going to be called. Call provisions exist with most debt instruments. The call date is an earlier than the maturity date when the issuer, at his option, can retire the debt. This call date is disclosed on a call schedule which also may contain different prices at which the call can be exercised. It is generally a decreasing price starting at some value above par for the early years, but never goes below par.

To spot which of your securities may be called early, check the yield for similarly rated securities. If the coupon rate is 1% or more above this yield you can assume a call is likely. Check the next call date and price of the security, something you can find on our website or even on some brokerage statements. Note that once the first call date is reached, a security is callable anytime thereafter. The usual practice is to call the security on a payment date. Many debt instruments currently carry interest rates well above current market refinancing rates. This means a call on such debt instruments is likely. In fact, a failure to call could be a sign of weakness.

Note that when using trust preferreds created by a brokerage firm, i.e. third party trust preferreds, look at the coupon rate of the underlying corporate bond. For example, the 8.375% Motorola CBTCS had an underlying 6.5% non-callable bond. The brokerage firm originating this issue won’t call it unless the underlying bond trades at a price below what they paid for the bonds when they set up the trust since they stand to pocket the difference between that price and the call price. In this case, Motorola is not a party to the refinancing decision. In other instances, however, the underlying bond may trigger a call. Be aware of from where the call can originate.

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The likely call risk also explains why the yield spreads on preferreds are significantly above those for corporate bonds which have a much larger and longer universe, i.e. how much above par value are you going to pay if the security can be called away tomorrow? In fact, you should look at our recommended list of bonds and preferreds to see what the yield to call rather than current yield is. I note that on the preferred list, over a dozen issues have a negative yield to call. These securities are prime sell candidates. Note also, if you sell a preferred selling at $27, the $2 premium above its $25 call price will disappear over time and become high tax interest income. If you sell it at $27 it becomes a long-term capital gain. What works best for your tax return?