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Back in ‘the good old days’, before the Bernanke/Geithner cartel imposed their transfer of wealth from savers to debtors, callable bonds could be counted on offering a slight premium to their non-callable counterparts. (The rule of thumb for the premium was 25bps.) The downside, of course, of chasing that premium was being confronted with an adverse call. But that problem could be avoided by never paying more for the bond than a nearby call offered. OTOH, if the bond could be bought at a discount to the call price, and the call did happen, then a windfall profit could be grabbed. Such a thing just happened to me.

Last year about this time, I bought 5 of Barclay’s 6-1/4’s of ’25 at 95.219 (all-in). Recently, I received notice from Zions that the issue is being called at the end of this month. So, what would have been a 6.8% YTM over a 14.5 year holding-period has been converted to an 11.5% YTM for a one year holding-period. In the short term, that is good. Nearly doubling one’s expected return is always fun. But in the long-term, being called is not so good, because now the cash has to be put back to work, and bond prices suck majorly. E.g., the best-yielding Barclay’s bond of comparable maturity, their 4’s of ’25, would offer 270 bps less per year than I would have made had my bond not been called. Ouch! That’s a huge difference.

OTOH, expecting to roll and to get a comparable return is very unrealistic, and this is how I think the matter should be thought of. Money put to work as investments is money that cannot be needed any time soon. It’s just cash that one wants to be available at some future date. So an investor’s chief task is the preservation of purchasing-power, which requires about an 8% return (after taxes and inflation). To make less is to lose money. To make more is to gain money. But, on average, obtaining much more than 8% from bonds is tough to do unless one is overweighting the credit-worthiness portion of the portfolio. In other words, a properly-constructed bond portfolio will typically consist of four tranches:

(1) Bonds that are purely interest-rates bets and that will never offer a real rate of return except in the most unusual of circumstances. E.g., CDs, Treasuries, most Agencies, and very superior munis and corporates.
(2) Bonds that are more of a bet on interest-rates than credit-worthiness, e.g., the typical, mid-tier, invest-grade muni or corporate that, again, typically won’t offer a real rate of return after taxes and inflation, though the shortfall is tolerable.
(3) Bonds that are predominately credit-worthiness bets. Classically, this would be corporate ‘fallen angels”, or upper-tier junk, and modest, real gains can be made in this tranche.
(4) Bets that are that purely credit-worthiness bets. Here, very serious money can be made, though the risks are definitely proportional to the gains.

According to how one allocates cash among the four tranches, different investor profiles can be obtained. E.g., the timid might over-weight interest-rate bets, and the fearless might over-weight credit-worthiness bets. FWIW, my preference is this allocation:

20%, top-tier invest-grade.
40%, mid-tier invest-grade.
30%, upper-tier junk.
10%, lower-tier junk.

Charitably, Barclay’s could be considered mid-tier, invest-grade. Therefore, my expectation should be to lose money from buying their bonds, which is what a 6.8% rate of return did for me. It lost me money. Not by much. But steadily, my purchasing-power was being eroded. OTOH, there really is a limit to how much credit-risk I’m willing to accept and/or can manage responsibly. So I look at the matter is this way. Cash at my credit union offers 2%. So I could take the money from the called bonds and park it for a couple of years and still break even compared to what the money would have done for me had I not been called. OTOH, anticipating the call, in the last four days I’ve spent a $4,500 on four new positions (two lower-tier, invest grade, two lower-tier, junk, six bonds total) that will offer me an average YTM of 18.2%. [that's not a typo] So only $500 of the call will need to be parked, and that’s a tolerable increase in cash relative to AUM (which I try to maintain at less than 5%).
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