Stock Market

In the United States, most, but not all, fixed-income securities pay interest twice a year; on the annual anniversary of the original issue date, and again six months later (in Europe, most bonds pay interest annually). For example, five-year U.S. Treasury notes yielding 6.625 percent and due May 2007, pay interest in May and November each year. Plus, the Treasury will pay you back the amount you lent it (your principal) on the maturity date, May 2007.

Call Feature

Some fixed-income investments include a "call" feature. What is this? Well, let's say you have a home mortgage. This is essentially a fixed-income security you sold to your bank. You, as the borrower, agreed to make fixed monthly payments and to pay off the principal by a final maturity date.

You have, however, the right to pay off your mortgage in advance and to refinance your mortgage to take advantage of declining interest rates. This right is the "call" feature. You can "call" your mortgage anytime and pay it off. Some U.S. Government bond issues and the vast majority of corporate and municipal issues also have call features. These give the issuer/borrower the right to pay off ("redeem") the bonds issued.

TIP: Call features benefit only the original issuer; they never benefit the purchaser or owner. Therefore, either don't buy any issues with a call feature, or be very careful about incorporating them into your bond portfolio.

Why would the borrower want this right? Well, let's see an example of Treasury notes paying 6.625 percent interest and maturing in 2007, and pretend the issue is callable. What if interest rates declined to 3 percent? The Treasury would love to be able to pay off the note at 6.625 percent and issue a new note. It would save billions of dollars in interest expense!

This would be a drag for you, though, because now you no longer have a 6.625 percent note. Sure you got your principal back, but now if you want to reinvest it, the best you'll do is a new Treasury note at 3 percent. Your interest income has been drastically reduced by this swift move and there's not one thing you can do about it!

Now, let's assume that rates increase to 8 percent. You would be very pleased if the Treasury would call your note so you can reinvest at the higher rate, but the Treasury sure doesn't want to pay 8 percent when it's got you locked in at 6.625 percent.

In this case, the Treasury would not exercise the call right.