To call or not to call?: optimal call policies for callable U.S. Treasury bonds

Until 1984, the U.S. Treasury typically issued its long-term bonds in callable form. A number of these securities, totaling $93.8 billion in face value, remain outstanding. After a call protection period, usually five years prior to maturity, the Treasury can call the bonds but must give prior notification of intent to call. This article develops a decision rule, which takes account of the prior notification requirement, when it is optimal to call such bonds. ; The decision of whether to call is based on the current level of interest rates and their volatility. For a call to be optimal for the Treasury, interest rates must be sufficiently low (relative to the bond's coupon) and the potential benefits of waiting--on the chance of even lower interest rates--should be insufficient to compensate for the costs of continuing to pay the higher coupon rate for another six months. After developing these ideas, the authors use a numerical example to demonstrate their application. They conclude that, at least in recent years, the Treasury has called bonds optimally. The model they use, which is also applicable to agency, corporate, and municipal callable bonds, specifies conditions under which the Treasury should call outstanding callable bonds in the future.