Risk Considerations Risk Considerations   


Fixed-Rate Features

Fixed-rate debt securities have fixed interest rates and fixed maturities. If held to maturity, subject to the creditworthiness of the issuer, they offer the benefits of preservation of principal and certainty of cash flow. Prior to maturity, however, the market value of fixed-rate securities fluctuates with changing interest rates. In a falling-rate environment, market values will rise, with the degree of increase determined by the time remaining to maturity. In a rising-rate environment, prices will fall, creating the risk of loss when securities that have declined in market value are sold prior to maturity. Investors should remember that as with most fixed income investments, Agency securities are subject to certain risks, including but not limited to, call risk, interest rate risk, and complex structures.

Callable Securities

Callable securities give the issuer the right to redeem the security on a given date or dates (known as the call dates) prior to maturity. Essentially, an option to call the security is sold by the investor to the issuer, and the investor is compensated with a higher yield. The value of the call option at any time depends on current market rates relative to the interest rate on the callable securities, the performance of assets funded with the proceeds of callable issues, and the time remaining to the call date. The period of call protection between the time of issue and the first call date varies from security to security.

Common Features of Callable Securities

The various types of call features are:

  • European - callable only at one specific future date
  • Bermudan - callable only on interest payment dates after the initial call date
  • American - callable on and any date after the initial call date
  • Canary - callable for a period of time (more than once) and if it's not called, it converts to a bullet (non-callable)

In almost all cases, the right of the issuer to exercise a call is deferred to the end of an initial "lock-out period." Bonds also can be callable quarterly, or even monthly. Documentation for callable securities usually requires that investors be notified of a call within a prescribed period of time. Most agency issues are callable in full, but some may be called in part, depending on the terms of the issue. These securities are described by their lockout and maturity dates. For example, a five-year note callable after one year is referred to as a "five no-call one year". A two year note callable after six months would be referred to as a "two no-call 6 month" note.

The Valuation of Callable Debt

When interest rates move, the values of almost all debt securities change. For non-callable fixed-rate instruments, the price of the security will go down as rates go up (and up as rates go down) so that yields remain in line with prevailing market rates. For securities with embedded options, however, the market price also has to account for the change in the value of the embedded option. A call option, for example, generally becomes more valuable to the issuer as interest rates fall.

Step-Up Securities

Step-up securities do not pay a constant interest rate over the life of the security. Instead, an initial fixed interest rate is paid until a specified date (generally, but not always, the first call date). This initial coupon then resets or 'steps up' to a higher predetermined rate on specified dates until the issue is called or until maturity. A single security can have more than one step-up period. If the coupon has more than one adjustment date, it is called a multi-step.

Features of Step-Ups

Step-up securities are typically structured so that they are callable by the issuer on any interest payment date on or after the first call, or step-up date. Like all callable bonds, issuers commonly exercise the call option if interest rates fall. If interest rates rise, the step-up structure may be more helpful to an investor than a fixed-coupon security since the higher coupons later in the life of the security may provide additional interest income in the event the bond is not called.