March 30, 2010 in Business

What to do when bonds are called

Greer Gibson Bacon
 

Q. My wife and I are retired and have a municipal bond portfolio. A lot of bonds have been called lately and we don’t know how to replace the income. Any thoughts? – Allen B.

A. Most issuers of municipal bonds (cities, counties and states) reserve the right to “call” their bonds for early redemption, if certain conditions are met. And like homeowners with costly mortgages, they rush to refinance when they can do so at lower rates. Unfortunately, this means investors get their money back at a time when it’s difficult, if not impossible, to find a place to reinvest it.

Here’s a basic strategy you can use to manage this situation in the short run. It’s based on the current rate environment and how rates are likely to change in the coming years. In general, you need to accept two facts and act accordingly.

Rates are at extreme low levels. For example, the key Fed funds rate is hovering around zero. But this is temporary. Rates will rise to normal levels as the economy gains momentum and the government finances its deficit spending. In the past, they’ve even risen to extreme high levels, based on inflation and other factors.

Bond prices react to changes in rates. When rates fall, their prices rise. And when rates rise, bond prices fall. Also, the longer the term of a bond, the more it rises or falls in value. By contrast, cash equivalents hardly budge.

For now, you should be guided by these facts. This means parking money you want to reinvest in bonds in cash equivalents and ultra-short bonds. Since their prices will be fairly stable as rates rise, this will keep your money intact. So, when higher rates emerge down the road, you will be well-positioned to take advantage of them. This strategy requires a willingness to accept low yields in the short run. But it should reward you nicely in the long run.

Down the road, it’s important to build call protection into your portfolio. There are several ways to do this. You can buy bonds that cannot be called, when they are available. Or you can buy bonds that can’t be called for five or 10 years after they’re issued. And you can avoid those with extraordinary calls, like housing or hospital bonds.

Finally, you can buy bonds at a discount from face value. Although they may be called, you will at least get a bonus because they will be redeemed at face value or a modest premium. When you build call protection into your portfolio, you will give up a little yield. Although it may not eliminate calls altogether, it will help at times like these.

A word of caution. If you’re considering using ultra-short bond funds in lieu of cash equivalents and ultra-short bonds, you should read, “Ultra-Short Bond Funds: Know Where You’re Parking Your Money.” Prepared by the Securities and Exchange Commission as an investor advisory, it can be found at the SEC’s Web site, www.sec.gov.

Greer Gibson Bacon is a certified financial planner and member of the local Financial Planning Association chapter. Readers are invited to submit questions on financial planning to be answered each Tuesday. Send questions to askaplanner@spokesman.com.

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