A newcomer at buying bonds could be in for a little surprise
The buying spree that began late last week on the stock market was, the experts told us, led by big institutional investors who came out of the woodwork with billions of dollars to set trading records.
In the bond market, it is the individual investors who are becoming an increasingly powerful force, particularly if you look at the number of ''odd lot'' transactions. Most bonds have a face value of $1,000 and an odd lot is anything less than 100 bonds, although some issuers regard 25 and under as odd-lot territory.
In the municipal bond market, the number of odd-lot transactions has increased about 240 percent since 1980, says Frank O'Brien, chairman of J. F. Hartfield & Co., a New York bond broker. During the same period, the size of these transactions has increased 60 percent, to the point where odd-lotters bought at least 20 percent of all new muni bond issues brought to market. In an average year, odd-lot investors take part in five or six municipal bond transactions, each of which involves 10 to 25 bonds.
Many new muni bond investors may not be aware that their bonds have a little surprise buried in the fine print: a ''call'' provision that allows the issuer to buy back the bonds before maturity, sometimes 10 to 20 years early. For example, bonds issued three or four years ago when interest rates were at an all-time high may now be eligible for early calls.
Last week, we discussed the way corporations sometimes undertake odd-lot repurchase programs to cut down investor relations costs, buying back stock from people who own fewer than 100 shares. These programs are voluntary; if you want to keep your three shares of stock, you can.
With bonds, however, the repurchase programs, or calls, are not voluntary. Some investors may, in fact, not know about it at all, since, for several months at least, the only notification comes through a long list of bond numbers printed in tiny type in financial newspapers. Some brokers will occasionally watch for these numbers and call their customers, but you can't guarantee it. Eventually, however, the issuing agency will send a notice to holders of registered, non-coupon bonds.
What does it take to set off an early bond call? Usually it is lower interest rates. If a municipality or corporation can save money by having its outstanding debt in the form of lower-interest bonds, it will undertake a refunding, calling in some or all of the higher-rate bonds and reissuing new ones at the lower rate. If, as some economists predict, interest rates make a downward move in the next year or so, bondholders could see more early-call notices in those financial columns.
One of the dangers of an early call for bondholders is the sudden loss of those periodic interest payment checks, which may be an important source of income for many people. People who still have coupon bonds (no longer available, thanks to the 1982 tax law) could also have an unhappy surprise when they try to redeem a coupon and find the bond was called several months ago. At the least, the single coupon won't be redeemed, meaning the investor has lost perhaps six months' interest.
Fortunately for the investor, holders of odd lots do not get any worse deal in an early call than anyone else. ''If there is a refunding of a whole issue, there is no differentiation. Everybody gets the same price,'' said Larry Morris, senior vice-president at Butcher & Singer. If there is a partial refunding, numbers will be drawn at random, to ensure as much fairness as possible.
The problems may come because many odd-lotters are not sufficiently plugged into the communications systems to receive timely notification of an early call.
''Investors have to be aware of call dates, especially on bonds that were issued two or three years ago,'' Mr. Morris recommends. ''These may be subject to early call now.''
''You should check your bonds at least every six months or so,'' says Marilyn Cohen, a broker with Cantor, Fitzgerald & Co. in Los Angeles. ''Look for any that are callable soon and call your broker to see if any have been called.''
Although bondholders can sometimes expect to be paid a small premium when there's an early call, ranging from one-half to 3 percent of their capital, this bonus generally does not make up for the lost income that would otherwise be paid if the bonds could have been held to maturity.
If you are investing in bonds and they have a call date coming within the next few months, you may want to talk to your broker about doing some refunding of your own. While you are unlikely to find any bonds with no early-call provisions at all, look for bonds with the longest call-free period you can find. If you want a slightly higher yield and don't mind early calls (this may be a short-term investment anyway), then a shorter time frame may suit you. Issuers sometimes compensate for early-call provisions with a better interest rate.
If you want to avoid this fuss altogether, but still want to be part of the municipal bond market, where yields are free of federal taxes, you might consider a municipal bond mutual fund or unit investment trust. Here, you won't have to think about early calls, you will be part of a diverse portfolio of bonds, and you will be able to get in and out whenever you like, to the degree you like.
''If someone is considering buying 10 bonds or less, I would tend to recommend a fund,'' Mr. O'Brien of J. F. Hartfield said. ''You're buying a share of a portfolio that will have many more bonds than the average investor could afford.''
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