Making Securities “Available for Sale”

Emily Hollis, ALM First Financial Advisors
August 4, 2006

Callable securities can present unique opportunities/risks depending on various interest rate outlooks. We will often allocate a small percentage into the portfolio for reasons explained in this article. In a falling rate environment, callables have little to no potential for gains. However, in a rising rate environment, most callables will outperform bullet securities.

Callable securities allow the issuer the right to “call away” or mature the security prior to maturity. An issuer will exercise this “right” when rates fall, for they can reissue the security at a lower funding cost.

All callable securities are not made equal for there are many different types of call options. The issuer can offer a one-time option, which is called a “European” call, or a continuous option which is called an “American” call. Lastly, call options can have different call frequencies such as annual, semi-annual, quarterly, or even monthly.

If you believe that rates will fall, bullets will outperform all non-derivative investment sectors. However, in rising rate environments, callable securities outperform bullets with equal maturities, especially those that have the greatest amount of call optionality at the time of purchase.

Here is an example. Suppose that you are considering investing in a five-year callable with a one-time, six-month call option versus a five-year bullet. The five-year callable security is trading at a spread of 50 basis points over the five-year bullet. Let’s suppose that rates rise by 75 basis points over a period of six months. The security will not be called and will therefore turn into a bullet. Your newly formed bullet is yielding 50 basis points higher than the alternative bullet and therefore has less of a price loss. Now let’s suppose that rates move up only 25 basis points. In this case, your security will probably be called. That’s all right, for you can most likely invest in a 4.50 year bullet security at a higher rate.

Callable securities have less of a price loss in a rising rate environment. Given the example above, the price loss of a bullet in the up 100 basis point scenario is approximately 4% (depending upon the coupon). However, the price loss of the callable is about 2.50%, for the call option has lost value and the spread has narrowed. Theoretically, callable securities (where the coupons are close to market) have negative convexity (securities that lose more income should rates rise than gain should rates fall) in the base-case scenario; the negative convexity lessens (and can turn positive) as interest rates rise.

If you believe that interest rates will rise in the near future and then subsequently fall, consider purchasing a security with a short one-time call option. For example, a five-year security with a one-year, one-time call option will give you call protection but rates will most likely fall in 2007 and the security will be called. If you believe that rates will rise between now and year end, invest in a five-year security with a three-month, one-time call. In today’s market, you will receive an additional 50 basis points for the risk, and if you are lucky, the security will turn into a bullet at the time that rates fall. If you can’t find these in the market, your corporate credit union can most likely structure one for you.

So in summary, callable securities can have a place in an investment portfolio. Having said that, you might want to save the idea for a later point in time. Economic indicators are now pointing toward the potential for falling rates by the end of the year. At this point in the interest rate cycle, we recommend increasing the allocation to bullet securities and decreasing exposure to callable securities.

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact her at 800-752-4628 or ehollis@almfirst.com.