Call risk

Definition

Call risk is the risk that a bond issuer will redeem their bonds before the scheduled maturity date, usually due to falling interest rates. This can negatively impact investors who may have to reinvest their funds at lower rates or find themselves in an unfavorable market. Call risk is a key consideration for fixed income securities as it affects the expected returns and overall investment strategy.

5 Must Know Facts For Your Next Test

1. Callable bonds typically offer higher yields compared to non-callable bonds to compensate investors for taking on call risk.
2. The likelihood of a bond being called increases when interest rates decline since issuers can refinance at lower rates.
3. Call risk can lead to reinvestment risk, where investors may not find favorable investment opportunities for the returned principal if their bonds are called.
4. Investors should review the call provisions in bond agreements to understand when and how an issuer may exercise their right to call.
5. Call risk impacts pricing, as callable bonds often trade at a discount compared to similar non-callable bonds due to the added uncertainty.

Review Questions

• How does call risk influence an investor's decision-making process when selecting fixed income securities?
  • Call risk plays a significant role in an investor's decision-making as it can alter the expected cash flows from a bond. Investors must evaluate the likelihood of a bond being called and consider whether the potential yield compensates for this risk. A higher call risk might lead an investor to favor non-callable bonds or those with more favorable call terms, ensuring they achieve their investment objectives while managing potential uncertainties.
• What strategies can investors employ to mitigate the effects of call risk in their fixed income portfolios?
  • To mitigate call risk, investors can diversify their fixed income portfolios by including both callable and non-callable bonds. They can also consider investing in bonds with longer maturities or those with specific features that limit call options. Additionally, maintaining awareness of market conditions and interest rate trends can help investors anticipate potential calls and adjust their investment strategies accordingly.
• Evaluate how changes in interest rates affect call risk and the overall investment landscape for fixed income securities.
  • Changes in interest rates have a direct impact on call risk, as falling rates increase the likelihood that issuers will call their bonds to refinance at lower costs. This creates a dynamic investment landscape where investors face reinvestment challenges when their callable bonds are redeemed. Understanding this relationship allows investors to make informed decisions about bond selection, considering factors like yield spreads and market conditions, ultimately influencing their asset allocation within fixed income investments.

Related terms

Callable Bond: A callable bond is a type of bond that gives the issuer the right to redeem the bond before its maturity date, usually at a predetermined price.

Yield to Maturity (YTM): Yield to Maturity is the total return anticipated on a bond if it is held until it matures, taking into account its current market price, par value, coupon interest rate, and time to maturity.

Interest Rate Risk: Interest rate risk is the potential for investment losses that can result from a change in interest rates, impacting the value of fixed income securities.