Pub. 8 2019 Issue 3

The CommunityBanker 22 A best-selling book from the 1990s, “Why Things Are,” took a humorous look at curiosities originating from everyday existence, with the modest goal of answering “every essential question in life.” This column has a more ambitious purpose: to clarify a few of the phenom- ena surrounding your investment in bonds. So, put on your seat belts as we head out for a ride on the fixed- income highway. Why do continuously callable bonds have a higher yield than bonds with only one call date? An investor in a callable bond actually does two things simultaneously when he or she makes the purchase: 1. the buying of the bond from the issuer, and 2. the selling of the right to prepay the debt early to the issuer. For bonds with multiple call dates, the issuer pays something for each right. In aggregate, the value of all the call options as of the issue date is reflected in the higher yield compared to a non-callable bond, or one with one only call date. Why do mortgage-backed securities priced at 100.00 have different yields than the stated coupon? For this answer, we have to do a two-step move. First, let’s review what bond-equivalent yield (BEY) means. The yield on a bond has a standard calculation that assumes semi-annual interest payments in arrears (meaning at the end of the pe- riod), and principal at maturity date. For example, if you buy a new two-year agency bond, your first interest date will be exactly six months from original settlement date. Mortgage-backed securities (MBS) differ in two ways. First, some interest payments are received monthly. That’s good from a BEY standpoint. However, MBS also have this nice little convention known as “delay days” before any prin- cipal or interest are paid. That’s bad for BEY purposes. Most mortgage securities have delay days ranging from 45 to 85 days. Factoring in the delay of both principal and interest over a period of time probably means the bond-equivalent yield for a mortgage will be less than the coupon, at par. Why Bonds Are Riddles, enigmas and other investment mysteries By Jim Reber F E A T U R E