With mortgage rates sliding, thousands of homeowners are happily refinancing their loans.
But when the U.S. Treasury refinances a little of its debt, people who have come to depend on income from Treasury bonds start crying foul.
Still, the government likes to save money on its interest payments, too. For that matter, so do municipalities and corporations.
As a result, investors who do not know about -- or ignore -- the consequences of bond "calls" are getting a painful education as public and private bond issuers sell new debt at today's lower interest rates, then use the proceeds to pay off old bonds issued with higher interest rates.
Those lessons are even more painful for unsophisticated investors who were sold "callable" bonds by brokers who touted the securities' high yields but failed to warn their customers that the bonds might be called before they matured. In most cases, financial specialists say, these brokers knew, or should have known, that the call provision was one reason for the higher yield.
"A bond call does put a crimp in your cash flow," says John Breazeale, senior vice president and director of fixed-income securities at Mackenzie Investment Management in Boca Raton, Fla.
For example, he explains, a $30,000 municipal bond bought with a 7 1/2 percent yield produces semiannual income payments of $1,125. But if that bond is called and replaced with one yielding 6 percent, the payments are cut to $900.
A call can also mean a loss for investors who were sold existing bonds through the secondary market. Those bonds may have been bought at a premium to "par" -- that is, for more than 100 cents on the dollar.
"Calls are clearly going to happen," says Peter Hegel, chief investment strategist with Van Kampen Merritt, a Chicago brokerage. "Municipal bonds are generally issued with a 10-year period until the first call. Many of those bonds out now have [interest] rates in the mid-teens.
"For them, time's up."
Bond calls have been coming with increasing frequency in the municipal and corporate market in the last few months. In the third quarter, U.S. corporations sold some $22 billion of new debt pay off old bonds, nearly five times the level of the same quarter last year, according to Securities Data Corp.
But it was the Treasury's call earlier this month that got the public's attention. In its first call since 1962, the Treasury said that it was paying off a $1.8 billion issue of 7 percent, 20-year bonds due to mature in August 1993.
Those bonds will be redeemed next February, saving the government some $18 million in finance charges.
The bonds involved represent a small fraction of the $2.3 trillion of Treasury securities outstanding, and the vast majority of Treasuries can't be called. Still, the event should serve as a reminder to investors that the security of income from bonds, even Treasury bonds, can be illusory.
Bond calls should not be a surprise to institutional investors, who are supposed to know what to look for in a prospectus, says Charles Wallis, president of Back Bay Advisors, a subsidiary of the New England Investment Cos. in Boston.
"The institutions should know what they're doing," he says. "It's the individuals who can get hurt. If [a broker] fails to mention a call feature, it's an 'oversight.' The average investor doesn't have a computer screen on his desk" to see if prices of particular bonds reflect the presence of call features.
While bond calls are a problem, some perspective is in order, financial advisers say. With inflation hovering around 4 percent, many of today's bonds offer a real rate of return, after adjusting for inflation, of 3 percent to 4 percent. So even if an investor has some bonds called and has to reinvest the money at a lower rate, the new returns are positive. In the late '70s and early '80s, yields were in the mid-teens, but inflation was even higher, resulting in negative returns.
"Real rates of return are very attractive," Mr. Breazeale says. "For the people who reinvest bonds in other long-term instruments, the returns are reasonable."
"A 3 or 4 percent real rate of return is probably going to be the new standard," Mr. Wallis says.
In the future, he adds, people should think of rates of return in terms of what's needed to save for long-term goals, such as college or retirement, rather than comparing bond yields to the interest rate on debt. If debt becomes a smaller part of the average American's financial picture, he believes, they won't be as tempted to take on added risk by reaching for yield.
Not surprisingly, given today's lower interest rates, most new bonds come with call protection -- that is, they can't be called. For example, about 90 percent of the new corporate bonds are non-callable, Mr. Wallis says; five years ago, about half could be called.