Understand the key differences between government, municipal, and corporate bonds
Wayne from Chantilly, Virginia: I have a question corporate bonds, municipal bonds, and government bonds. Can you explain what callable bonds are and how they compare to the corporate, the munis, the government bonds? And, are these callable bonds subject to the same adjustments in the upcoming interest rates on the callable bonds? Is that something that an investor like me should have in their diversified portfolio?
Ric: Well, it's funny. I haven't talked about callable bonds in 10 or 15 years. Let me see if I can remember how to talk about this used to be a big deal, but it's not as big a deal at the moment, and you'll see why in a second. The short answer is this weighing a callable bond is not a different kind of a bond. You mentioned government bonds, corporate bonds, municipal bonds. A callable bond is a feature of one of those. In other words, a corporate bond might have a call feature inside of it. What is the call feature? Well, in short, heads, they win. Tails you lose. Let me explain what I mean by that. Let's say that you are a corporation and you're issuing a bond. You want to pay as little as possible to borrow the money that you're borrowing. I mean, that's what a bond is, really. They're borrowing money, you're lending them money and they're paying you interest in exchange. So you might get a 10 year bond from a corporation that pays, oh, we'll say, four percent in interest. And given what's going on in the economy, you're happy to earn four percent for 10 years, and the company is willing to pay four percent for 10 years. But interest rates then change. It's a year later and interest rates have gone down. And that company has the ability to issue a new bond at only three percent, but they're stuck paying you for. So what do they do? They activate their call feature. A call feature lets the borrower, meaning the corporation that issued the bond. The call feature lets them call the bond back.
Ric: In other words, if you had given them $10000 for that bond for 10 years, they don't have to wait 10 years to pay you back. They can pay you back today, and that means they're going to replace the debt that they gave you four percent with brand new debt at only three percent if interest rates go down. The corporation wins because they get to refinance their debt at new, lower rates. It's bad news for you as the lender because you were earning four, but now they called your bond. You got your money back. You've got to reinvest it at new lower rates you were earning four. Now you're only going to earn three. So if interest rates go down, they win. [00:19:00] You lose. But what if interest rates go up? Well, remember, the company wants to borrow money as cheaply as possible if interest rates were four percent and they rise to five percent. The company is not going to execute that call feature. They're going to sit on it because they're going to be happy to pay you four percent for as long as possible instead of having to borrow new money at new higher rates. So if interest rates go up, they win. You lose because you're only earning four percent. If you had bought a brand new bond today, you'd have gotten five percent. So you're stuck with a lower income, a lower interest rate. So if interest rates go down, they win. If interest rates go up, they win. In other words, heads, they win, tails you lose. So be careful about buying a bond that has a call feature. Simple as that, right?
Wayne from Chantilly, Virginia: Ok, Rick, appreciate it. That answers that question. Appreciate the input and [00:20:00] thanks very much. Enjoy listening to your new show now.
Ric: Well, I'm really glad you called Wayne. Thank you and have a wonderful day. You can learn more about cool features and buying bonds. The difference between government bonds and corporate bonds. Municipal bonds in my book The Truth About Money. Time now for everybody's favorite segment of the program. Visit by my wife Jean Edelman Jean is a student of the healing arts, reiki, traditional Chinese medicine, homeopathy, acupuncture and, of course, macrobiotic and plant based cooking. Here's Jeanne.
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