Call Risk

Definition

Call risk refers to the possibility that a bond issuer will redeem a callable bond before its maturity date, typically when interest rates decline. This can lead to investors receiving their principal back sooner than expected, which might force them to reinvest in lower-yielding securities. Understanding call risk is crucial for assessing the overall return and pricing of callable bonds, which have different characteristics compared to non-callable ones.

5 Must Know Facts For Your Next Test

1. Call risk is more prevalent in callable bonds, where the issuer has the right to redeem the bond before maturity, usually during periods of declining interest rates.
2. When a bond is called, investors may not only lose potential future interest payments but also face reinvestment risk, as they will need to invest the returned principal in a lower interest rate environment.
3. Callable bonds typically offer higher yields compared to non-callable bonds to compensate investors for the additional call risk they assume.
4. The timing of when a bond might be called is uncertain, making it essential for investors to factor in call risk when assessing a bond's value and expected cash flows.
5. Changes in market conditions, such as falling interest rates or improved credit ratings of issuers, can increase the likelihood of a bond being called.

Review Questions

• How does call risk impact the investment decisions of bondholders in a declining interest rate environment?
  • In a declining interest rate environment, call risk becomes more significant because issuers are more likely to redeem callable bonds early to refinance at lower rates. For bondholders, this means they may receive their principal sooner than anticipated and lose out on future interest payments. This uncertainty can influence investment decisions as bondholders must consider potential reinvestment at lower yields, leading them to assess whether the higher yield on callable bonds compensates for this risk.
• Discuss how call risk affects the pricing of callable bonds compared to non-callable bonds.
  • Call risk plays a critical role in how callable bonds are priced compared to non-callable ones. Callable bonds generally have higher yields to attract investors due to the associated risks. When calculating their price, investors often incorporate the possibility of the bond being called early, which affects its market value. In contrast, non-callable bonds do not carry this risk and are priced based solely on their expected cash flows without concerns about early redemption.
• Evaluate the implications of call risk on an investor's overall portfolio strategy and how it relates to broader market trends.
  • Call risk can significantly impact an investor's portfolio strategy, particularly in environments where interest rates are volatile. Investors must weigh the benefits of potentially higher yields from callable bonds against the risks of early redemption and reinvestment challenges. As market trends shift, such as falling interest rates or economic improvements that might lead to increased refinancing activity, investors need to continuously reassess their exposure to callable bonds. A well-diversified portfolio may include both callable and non-callable securities to mitigate risks while still seeking attractive returns.

Related terms

Callable Bond: A type of bond that can be redeemed by the issuer before its maturity date at specified times and prices.

Yield to Call: The rate of return on a callable bond assuming it is called at the earliest possible date, providing an alternative measure of yield.

Interest Rate Risk: The risk that changes in interest rates will adversely affect the value of fixed-income investments.