[The following "ETF Issuer Perspective" is sponsored by PowerShares.]
We've arrived in September, a month when many have thought we may see interest rates rise for the first time in years. A rise in interest rates seems less likely now, but it's still important to think about the impacts of such a policy shift on investors' portfolios—especially their fixed-income allocation. For example, when interest rates fall, it's not uncommon for investors to see their callable bonds redeemed before maturity. For issuers, calling bonds is a chance to refinance debt at lower rates. For investors, a bond call is the source of considerable angst, but one for which they are typically compensated through higher yields—at least until the bond call itself.
But call features can also have unpleasant consequences when rates rise. Lurking just below the surface is something known as extension risk. Extension risk is a little-appreciated aspect of how callable securities can behave in a rising-rate environment. Too often, extension risk will sneak up on unsuspecting investors, leaving them wondering what happened. Extension risk can be prevalent in securities with imbedded call features and fixed coupons, which is often the case in mortgage-backed, municipal and fixed preferred securities. In my view, too many investors think of their preferred "stocks" as equitylike, ignoring the very bondlike risks that these hybrid securities typically carry in a rising-rate environment.
Declining Interest Rates Increase Call Risk
Extension risk stems from the fact that a callable security's sensitivity to interest-rate movements (typically measured by duration, which measures the price sensitivity of a fixed-income investment to interest-rate changes, and is the number of years it will take a bond's cash flow to repay an investor the bond's purchase price) is not static. It changes according to the likelihood of that security being called away. Generally, a callable security is less sensitive to interest-rate movements when rates are low, because that bond is more likely to be called. Conversely, a callable security is less likely to be called as interest rates rise, and its price becomes more dependent on interest-rate levels.
An issuer views a callable security much like you would your mortgage. If interest rates are low, you would take advantage of the opportunity to refinance. That's what the call feature allows the bond issuer to do—call away the higher coupon bond outstanding and replace it with a cheaper form of capital.
Because the market expects the issuer to take advantage of the call feature when interest rates are low, the bonds are typically treated as if they will be around only until their call date. Thus, a callable bond's sensitivity to interest-rate changes will be little different from that of a noncallable bond—known as a bullet bond—that matures on or near that call date.