Watch Out For Call Options In Your Long-Term Debt Instruments

There are a lot of long-term debt instruments that are issued by various institutions and are present in the portfolios of investors.

These bonds and debentures have been issued for long-term projects, and the good part about investing in these instruments, especially during high interest-rate scenarios, is that a person can ensure that they are getting a good return on their debt-portfolio investments.

These instruments look even more attractive when rates fall in the economy, but this situation can also lead to an impact for the investor in the form of premature redemption of the instrument. This can leave investors facing reinvestment risk because they will then have to invest at a lower rate of interest.

It is important to see why this occurs and be prepared for it in advance.

Long-Term Products

One of the features of infrastructure investments, or those with a long gestation period, is that they require long-term funds. This is usually raised in the form of debt by various institutions, and it presents a good opportunity for investors to invest for the long term in debt, and the return or interest that is offered on these instruments is also quite high.

Thus, one can have instruments like bonds and debentures that are 10 years, 15 years, or even 20 years long in the portfolio. Having some exposure to such instruments is a sound move for those who want long-term debt in their portfolio, as the time period of these will match some of the goals that they have.

Call Option

There is often a call option that is present on many of these types of long-term bonds. The call option is an option for the issuer of the bond to call back the bond and pay the money to the bondholder in the form of redemption. This makes it a premature redemption of the bond.

The applicable call dates are mentioned in the bond issue details, but usually, at the time of the investment, very few people pay attention to this aspect. The amount can be called back only on the specific dates that have been mentioned in the details, not at any point in time.

The investor who has invested in the bond then has to compulsorily offer the bond, and they will get the principal amount back. The investor at this point in time cannot say that they did not know about this feature, and they are bound by the conditions related to the bond.

Preparing Earlier

Such a situation usually arises only when the interest rates have fallen so that the institution issuing the bond finds it beneficial to redeem the amount raised earlier and then issue fresh debt at a lower interest rate.

This is a problem for the investor because, on one hand, their higher rate of return stops due to the redemption, and at the same time, their new return is now lower because when they go to reinvest the money, they will get a lower rate that is prevalent at that point in time.

This can throw the entire long-term planning out of gear, and hence, this needs attention. The real time when attention needs to be given to these instruments is during the time of investment or in periods of high interest rates.

This is the time to see whether there is a call option on the bond and the time period when it can be exercised. This is because the investor should be aware of the situation, and then they can plan ahead in case such an option is exercised.

A strategy regarding instruments to select and the time frame for their exposure to redeployment is necessary. Otherwise, it is only when the redemption takes place that they will know about it, and in such a situation, it will already be too late to do anything.

Arnav Pandya is founder Moneyeduschool