When a municipality borrows money through the bond market during periods of high market interest rates, it naturally wants to be able to refinance those bonds, just as you would want to refinance a high interest rate mortgage, if interest rates decline to lower levels. The issuing municipality includes a refunding provision in its bond indenture, which can be found in the issue prospectus. Corporations and the U.S. Treasury do the same. A refunding provision, or call provision, states a date on which the issuer can refund the bond and refinance it from the proceeds of another lower interest-rate bond issue.
1. Look for a call date or refunding date in the issue summary section of the prospectus of any bond you are considering buying. It might also have a redemption provision. Any words including but not limited to refund, redeem, refinance or call in the description of the bond issue should raise a red flag in your mind.
2. Ask about any call or redemption features if you are buying a bond in the secondary market or do not have a prospectus to study in advance. Don't be shy about demanding to see that information if your broker doesn't readily supply the information. Many brokers don't understand the importance of call provisions.
3. Look for the word refunding or refinancing in the title of a bond. That means that the bond has been issued to provide money to refund a previous issue. Even refunding bonds can have call or refunding provisions, so be careful to check before buying.
4. Analyze the effect losing the interest income from a refunded or called bond will have on your portfolio, and prepare for such an event. When market interest rates are lower than the coupon rate on your bond, you are likely to have that bond called and redeemed.
- When a bond is refunded or called, if you are a bond holder, you will lose ownership rights on that bond. It will be called away from you and you will be paid an amount of money as a principal repayment -- as though the bond had matured on the date it was called. Depending on the provisions in the bond indenture, this principal payment may be discounted, or lower than the $1000 face value you might expect. It may also carry a premium or higher amount than $1000, but it is common to redeem a callable bond at par, or $1000.
- Always ask for complete details of the call provisions. Some bonds have several call dates and different redemption prices depending on the call date. Another term to look for is sinking fund. This is another way of retiring a bond and you should know the terms of the sinking fund before you buy.
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