Premium coupon callable bonds offer advantages for fixed income portfolios in today's low yield environment. They provide higher yields than comparable short-term non-callable bonds due to their premium coupons and potential to be called. If not called, they provide a yield cushion to protect against rising rates. A Wisconsin municipal bond example demonstrates how a premium coupon callable bond can offer significantly higher yields to call and maturity than similar non-callable bonds, with reduced downside risk if rates increase.

1. Fixed Income Update
Premium Coupon Callable Bond Structures: A
Better Fixed Income Portfolio Defense
Michael Wolfson, Senior Fixed Income Investment Manager June 14, 2011
Anthony Tanner, CFA
®
, Senior Fixed Income Investment Manager
Since the beginning of the recent credit crisis, monetary policy programs have helped to
drive down borrowing costs for consumers and businesses. Unfortunately, it has had a
markedly less positive impact on fixed income investors seeking the safety of short-term
maturity instruments. The Federal Reserve Bank’s Zero Interest Rate Policy (ZIRP) has
driven down yields across most short-term maturities and fixed income asset classes,
putting short-term municipal, U.S. Treasury, and corporate bonds near historic lows.
3-Year Treasury vs. 3-Year Municipals
Source: Bloomberg, June 2011
The fact that short-term interest rates have remained diminutively low for such an
unusually protracted period of time has negatively impacted savers—especially those of
retirement age, who in many cases are dependent on fixed-income for living expenses.
Economically, fixed income investors have essentially redefined the money market
instrument from a par-priced instrument to that which yields one percent with the shortest
maturity possible. In recent years, achieving this mandate has required extending to 3-
years in maturity in both the taxable and tax-exempt sectors.

2. We recommend a more opportunistic approach to addressing the challenge of obtaining
bonds with: (1) attractive risk-adjusted yields, (2) shorter duration, and (3) minimized
interest rate risk exposure. This approach encompasses further diversifying our portfolios
across coupons and bond structures to include premium coupon callable bonds. This Fixed
Income Update highlights some of the advantages that premium coupon callable bonds
offer—especially those with short-dated call features—for a fixed income portfolio in
today’s low-yield environment.
Structure and Yield Analysis
First, it is important to understand there is an inverse relationship between bond prices
and interest rates—as interest rates rise, the price of the bond falls, and vice versa. The
sensitivity of a particular bond’s price to an increase or decrease in interest rates is known
as its interest rate risk and is commonly measured by a bond’s duration. Premium coupon
callable bonds carry coupon rates above prevailing market interest rates, and also grant
the bond issuer the right to redeem the bond prior to its stated maturity date. For that
reason, the pricing of premium coupon callable bonds is generally based on yield-to-call
because of the likelihood that issuers will retire high cost debt before maturity to reduce
borrowing costs. A bond’s yield-to-call reflects the effective bond yield if it were redeemed
at its call date. The yield-to-maturity represents the bond’s yield if it were held until the
stated maturity date.
Depending on the coupon rate and initial call date, this type of bond structure is often
described as a “cushion” bond or “kicker” bond for two reasons: (1) it has the potential to
cushion a bond’s price decline as market interest rates increase, and (2) should the bond
remain outstanding beyond the initial call date, the bondholder will amortize any purchase
premium and earn the higher prevailing coupon, resulting in increased income. This
explains why the yield-to-maturity is significantly higher than the yield-to-call for a given
bond’s purchase price.
The coupon/call structure that typically provides the greatest potential yield “kick” is one
in which:
The bond’s coupon rate is well above current market yields (typically one percent
higher)
The initial call date occurs within a relatively short period of time after the purchase
date
There is a greater time frame between the initial call date and the final maturity
date
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3. These types of coupon/call structures are commonly traded in the secondary market, and
typically represent bonds issued within the last 7-15 years, during periods of higher
interest rates.
Premium coupon callable bonds are priced in the market based on yield-to-call because
the marketplace treats them as if they will be called with certainty. Bond issuers have
incentives to retire high coupon issues rather than continuing to pay premiums above
market interest rates. As long as market yields remain below the coupon rate, a bond with
this type of structure will retain a short duration profile because of its short call date
schedule. It is important to understand that this short-term profile continues even in cases
when the issue is not called. The risk remains, however, that an increase in market rates
above the coupon rate would result in the bond’s pricing to its longer final maturity date.
This risk, better known as extension risk, reflects the uncertainty surrounding the
structure’s ultimate redemption or maturity date.
Nevertheless, both of these risks and the high coupon/short duration structure can provide
key advantages for a bondholder. The combination of maturity, uncertainty and extension
risk often results in this type of bond structure trading at significantly higher yields to both
the call date and maturity date compared to non-callable bonds of similar final maturities.
Further, its defensive premium coupon structure provides a cushion against market
interest rate increases throughout the holding period.
A Working Example
Although interest rates in the municipal and U.S. Treasury markets turned up sharply from
August 2010 to January 2011, they have since resumed a downward trajectory in response
to signs of tepid economic growth, reduced municipal bond credit fears, and lower
issuance. As a result, both 3-year U.S. Treasury Note and high quality municipal bond
yields are again hovering near one percent. This has left investors with an unappealing
choice of either buying short-term bonds at yields below one percent to minimize interest
rate risk, or resorting to go out as far as ten years by purchasing 10-year bonds to obtain
yields above three percent on high quality issues.
We seek to capitalize on premium coupon bonds in the secondary market that offer short
effective duration/maturity, and yet provide significant yield pick-up over comparable
maturity non-callable bonds. As an example, the State of Wisconsin sold $275 million of
Aa2/AA rated general obligation bonds in May 2011. In this issue the 3-year maturity
yielded only 0.99 percent. Rather than accepting such a meager yield, it is sometimes
possible to find a favorable alternative of that issue through the secondary market:
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4. Marinette County, Wisconsin General Obligation
5.00% due 12/01/21, first callable 12/01/13 (2.5 years)
Aa2/ NR
Yield to Call Yield to Maturity
Purchase 12/01/2013 12/01/2021
Price (2.5 years) (10.5 years)
$105.663 2.70% 4.33%
Compare this to similar maturities in the State of Wisconsin GO bond issue:
Yield to Purchase
Coupon Maturity Maturity Price
5.00% 5/1/2014 0.99% $111.488
5.00% 5/1/2021 3.04% $116.665
Notably, there are important advantages in the callable bond structure:
A much higher effective yield—regardless of the eventual maturity. Not only would a
bondholder obtain a significant yield advantage over the holding period until the call date,
the yield to maturity (should the bond remain outstanding for that long) will also be
significantly higher. Should the Marinette County bond remain outstanding until maturity,
the aggregate annual yield premium (4.33 percent vs. 3.04 percent) compounded for a
10-year maturity period will provide over 11.36 percent of additional total return.
The call feature mutes the purchase premium. In this example, both 10-year bonds have a
five percent coupon. But because the market treats the call feature as if the issuer will
redeem the bonds, it produces a much lower purchase price ($105.563 vs. $116.66). In
effect, an investor in the non-callable State of Wisconsin bond potentially risks 10 points of
additional purchase premium should market yields approach the five percent coupon rate
on the bond.
The premium coupon, short call structure of the Marinette County bond makes it a good
substitute for a comparable shorter non-callable bond, as the short duration component of
an investor’s portfolio strategy. When considering the State of Wisconsin issue, the yield
on the 5/01/2014 maturity was 171 bps less than the yield-to-call on the Marinette County
bond. In this case, the cumulative tax-free income advantage to the 12/01/2013 call date
(in 30 months) exceeds 425 basis points.
The key part of the analysis is that because the callable bond structure results in a
discounted (i.e. higher) yield-to-maturity than a comparable non-callable bond, the price
declines can be significantly less on the 10-year callable than on the 10-year non-callable
bond when market yields initially increase and remain below the coupon rate. In this
example, we see the 10-year market yield of 3.04 percent is well below the coupon rate of
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5. five percent. This is the essence of the “cushioning” effect. As this example demonstrates,
in a rising-rate environment an investor is rewarded with (1) both higher yield-to-call and
yield-to-maturity and 2) reduced downside risk compared to buying longer non-callable
maturities.
The Value Proposition
As illustrated above, the short duration and reduced volatility benefits of premium coupon
callable bonds are transparent and often compelling. They provide a tool to add short
duration securities to a fixed income portfolio with a smaller yield sacrifice. However, there
is another intrinsic longer-term value with this structure to a fixed income portfolio.
In our example a sharp spike in interest rates such as the one we experienced at the end
of 2010 can actually benefit the Marinette County bondholder. Higher future market
interest rates will reduce the probability that the issuer will call the bonds at the first call
date because the interest cost savings of doing so will been materially diminished.
Economically, this means the total return prospect for the bond—the likelihood such a
bond remains outstanding beyond the initial call date to provide bondholders its higher
yield-to-maturity—increases with concurrent increases in market yields up to the coupon
rate. This highlights a valuable diversification benefit of this structure for a fixed income
portfolio—a negative correlation with some degree of rising interest rates, a characteristic
that contrasts with the behavior of conventional non-callable bonds.
Further, the realization of enhancing long-term income via the above scenario occurs with
greater frequency than one might expect. One of the inefficiencies of the municipal market
is that bond issuers frequently do not exercise call features even when prevailing market
yields remain below coupon rates. This often occurs when the interest rate savings from a
refunding are outweighed by refinancing costs to the issuer. In other cases, the issuer or
primary obligor is not sufficiently incentivized for various contractual or non-financial
reasons to refinance despite the apparent interest expense savings of doing so. It is
important to remember, just because a bond is callable does not necessarily mean it will
get called.
Conclusion
We have demonstrated that high-coupon, short-duration callable bonds can effectively
serve as the short-maturity / duration component of a portfolio, providing an effective
substitute for short-term non-callable bonds, whose yields are currently at historic lows.
When conservative fixed income managers traditionally pursue diversification, credit
quality and issuers are usually their first considerations, along with some degree of yield
curve diversification to manage interest rate and reinvestment risk—the risk that coupon
payments are invested at yields less than a bond’s yield to maturity. However, the
introduction of broader diversification across bond structures to include a variety of
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6. coupons and call features/redemption dates can be a powerful asset allocation tool—one
that is often overlooked by investors and professional managers alike. Furthering
diversification in this manner can reduce overall portfolio risk and enhance long run total
return potential.
Achieving positive inflation-adjusted income and returns in a bond portfolio requires a
more thoughtful approach towards managing risk in the current low interest rate
environment. Utilizing less-followed fixed income opportunities such as “cushion” or
‘kicker” bonds, demonstrates how we are able to add value and increased risk-adjusted
return potential to client fixed income portfolios. We encourage you to speak with your
investment professional if you have any questions about this type of fixed income
strategy.
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