Risks in new agency structure.

• Author: Larson, Corinne

Federal agencies such as the Federal Home Loan Bank System and the Federal Home Mortgage Corporation (Freddie Mac) began issuing zero-coupon bonds in June 1997. Some dealers have been marketing the new Freddie Mac zero-coupon bonds to institutional investors. This article highlights potential problems for investors.

The new agency bonds typically have a maturity of 10 years or more and a call option of five years or less. Some of these bonds are callable at six-month intervals after an initial lockout period. During the summer of 1997 some of the bonds were sold through regional dealers at a discount to yield 8 percent to maturity. This attractive yield was used to lure retail investors, as a comparable yield for an agency bond paying a cash coupon with the same maturity and call structure would have been closer to 7 percent.

A yield of 8 percent may sound attractive on the surface; however, it may not be enough yield to compensate investors for the risk added by the call option. Investors purchase these bonds because they focus on the 8 percent yield to maturity and not on the negative value of the call.

When contemplating the purchase of a callable bond, investors should calculate the yield to call of the bond, which is the yield an investor would receive if the bond is called by the issuer prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to call, and the market price of the bond. Yield to call can be significantly lower than yield to maturity, which is the return a bondholder can expect to receive if the bond is held until maturity.

Investors should evaluate the yield to call under different interest rate scenarios and compare those assumptions against other investment options. Callable bonds may appear unlikely to be called at current interest rate levels. Shifting the yield curve downward by a minor amount, however, may greatly increase the likelihood that a bond will be called well before scheduled maturity.

Falling interest rates provide issuers with the impetus to call their bonds early, forcing bondholders to reinvest principal at a lower yield. This is known as reinvestment risk. While yield to call can look attractive under certain circumstances, buyers should take into consideration the lower reinvestment rates that will be offered for subsequent investments and should calculate an overall horizon return. Public investors must remember that they are not in the business to make...