On Wall Street, it's the Year of the Call -- and for income investors, the Year of the Bawl. Falling interest rates are pulling the rug out from under folks who thought they had locked up high income for life.
Billions of dollars worth of high-income bonds are likely to be "called in," or retired, this year -- much earlier than most investors had expected. They'll be replaced with securities paying lower rates.
What investments are at risk? Anything paying 2 percentage points or more above current interest rates.
You've been hit -- or soon will be -- whether you own individual bonds or shares in income mutual funds and unit trusts. High-income unit trusts could be hammered the hardest because, unlike mutual funds, they cannot easily sell off bonds that are vulnerable to an early call. So the trusts are likely to lose some of the profits that they -- and you -- expected from the investment.
What do you lose when a bond is called? First, you lose the double-digit income that has been adding a little luxury to your life.
If you bought the bond at par (face value, usually $1,000), your principal is returned intact, generally with a little sweetener on top. But you lose the capital gain you earned on the bond when interest rates declined.
If you paid more than par for the bond (as you might have, for bonds carrying high coupon interest rates), you will take a capital loss. If you get a call on a convertible bond, you'll lose the higher price it was selling for in the open market.
You also could lose if you buy the older, high-income bonds or unit trusts on the market today that are in danger of being redeemed at a lower price. Yet many brokers are cheerfully selling them to investors who don't realize that they'll wind up with capital losses if the bonds are called.
Strictly speaking, the mortgages in Ginnie Mae securities cannot be called. But homeowners are paying off their high-interest loans ahead of time, which amounts to the same thing. So investors are getting back their principal earlier than they had planned.
If you (or your mutual fund) bought a high-interest Ginnie Mae for more than its face value, and it's repaid early, your ultimate yield will be much less than you expected. Many funds have been sending out letters to shareholders explaining -- none too clearly -- why falling interest rates are creating losses and leading to dividend cuts.
Only two groups of investors can truly count on continuing to get their double-digit yields.
First, those of you who bought taxable zero-coupon bonds. They are callable only at huge price increases from their present value, which isn't likely to happen. (But tax-exempt zeros may provide for an early call date.)
Second, those of you who bought Treasury bonds and mutual funds. Most Treasuries cannot be redeemed before maturity. Thirty-year T-bonds won't be called until 25 years have passed. So the 13 percent rates that far-seeing investors accepted in 1981 can last them another 20 years.
Today, mutual funds that buy long-term government securities yield about 8 percent to new investors. But it's not too late to get religion about the virtues of noncallable bonds. If, in the next recession, interest rates sink even more, today's Treasuries will look awfully good.
Most U.S. government mutual funds have been outperforming other taxable funds this year, according to fund analyst Michael Lipper, because they're not suffering the calls that are cutting into their competitors' yields.
To play safe with Ginnie Maes, longer-term investors might choose an older, low-interest Ginnie Mae security rather than buying the mutual fund. Those securities sell at a discount and pay current yields -- and their low-rate mortgages may not be refinanced for many years.
You also get pretty good call protection from high-yielding junk bonds, because most of those companies cannot afford to redeem their issues. On the other hand, you also run a much higher risk that the bond will default.
Many bonds promise no "refunding" for five to 10 years. This means that the company cannot sell lower-rate bonds to redeem your high-rate securities. But there are plenty of other ways a company can raise money to recall a bond.
So look for a nice, clean statement of "call protection" -- and insist that the broker quote you a yield to the bond's first call date rather than a yield to maturity. And if you own a "dirty bond" -- meaning one that is vulnerable to call -- consider selling it now, so you won't lose your capital gain.