Definition
Call risk is the risk that a bond issuer will decide to ‘call’, or repay, its debt before the bond’s maturity date. This often happens when market interest rates fall, allowing the issuer to replace existing debt with new, lower-interest debt. For the investor, it means an unexpected return of principal, often at a time when reinvestment opportunities are less attractive.
Key Takeaways
- Call Risk refers to the potential risk faced by bond investors when the bond issuer decides to retire its bonds before their maturity date. This usually happens when interest rates fall, prompting the issuer to call back its bonds to reissue them at lower interest rates.
- The second main point is that call risk can lead to capital loss and reinvestment risk, particularly for the bondholder. Capital loss occurs when bonds are called at a price below the market price. Reinvestment risk arises when the investor is forced to reinvest the proceeds from the called bond at a lower interest rate.
- Lastly, investors who are concerned about call risk can look for bonds with call protection. This refers to a period during which the issuer cannot call the bonds. Alternatively, they can seek out non-callable bonds which cannot be redeemed before their maturity date.
Importance
Call risk is important in finance because it refers to the potential for a bond issuer to “call,” or repay, their bonds before the maturity date.
This is usually done when interest rates are falling, allowing the issuer to refinance at a cheaper rate.
For investors, call risk is critical as it may disrupt their expected income stream.
If a bond is called early, investors might be forced to reinvest their funds in lower-yielding securities, thereby eliminating the potential benefits of a higher, fixed return over the life of the bond.
Understanding call risk allows investors to better manage their investment strategy and risk exposure.
Explanation
Call risk is essentially the probability that a debt security will be “called,” or repaid before its maturity date by the issuer. This is typically a provision that’s built into the conditions of bond contracts, allowing the issuer to pay off their debt early if certain conditions are met. The purpose of this feature is to allow issuers to take advantage of favorable shifts in the interest rate environment.
If rates decline, the issuer can call in the existing high-rate bonds and reissue new bonds at a lower rate, thereby reducing their cost of debt. However, for investors, there is a downside risk involved. Call risk refers to the potential drawback for bond investors when the market interest rates drop.
In such circumstance, the issuer is likely to call back the bonds, causing the investors to lose out on the interest payments they would have received until the maturity of the bond. Besides, they are also exposed to reinvestment risk, wherein they might have to reinvest the returned principal at a lower interest rate compared to the called bond. Thus, understanding call risk helps investors navigate the potential risks involved in the bond market.
Examples of Call Risk
Bonds: Call risk is commonly associated with bonds. If a company issues a bond with a high interest rate, but then interest rates in the market fall, the issuing company may choose to ‘call’ or buy back the bond at its face value before the end of its term. This way, the company can re-issue the bond at a lower interest rate. For investors, the risk lies in the potential loss of future interest income from such actions.
Mortgage-Backed Securities: Call risk also exists in mortgage-backed securities. If a lot of homeowners decide to refinance their mortgages because of falling interest rates, the investors of the security may face call risk. The risk arises when those homeowners pay off their old mortgage loans early, which in turn prematurely returns the principal to the investors, who are then forced to reinvest in a lower, less favorable rate environment.
Callable Preferred Stock: Companies often issue preferred stock with a call provision allowing the company to repurchase the shares at a specified price after a set date. Falling interest rates or a desire to lower capital costs can lead to call risk as the company can repurchase the shares, leaving investors to find new, potentially less profitable investments. Investors face the risk of the company calling the stock and potentially losing out on future dividend payments.
FAQs about Call Risk
What is Call Risk?
Call Risk is the risk that a bond issuer will redeem the bond before its maturity date, something that usually occurs when rates are falling.
What factors contribute to Call Risk?
Call Risk is often influenced by changes in interest rates. When interest rates drop, issuers will often choose to call their bonds and issue new ones at the lower rate.
How can Call Risk impact an investment?
Call Risk can impact a bond’s expected yield. If a bond is called early, the investor will miss out on some of the interest that they would have otherwise received.
How can an investor manage Call Risk?
Investors can manage Call Risk by investing in non-callable bonds or by diversifying their bond holdings. Investors can also factor in call risk when deciding which bonds to invest in.
Is Call Risk only associated with bonds?
While Call Risk is most commonly associated with bonds, it can also occur with other types of securities that have a call feature.
Related Entrepreneurship Terms
- Interest Rate Risk: The potential for investment losses due to a change in interest rates.
- Reinvestment Risk: The chance that an investor will be unable to reinvest cash flows (like coupon payments) at a rate comparable to their current rate of return.
- Prepayment Risk: The risk that a bond issuer will pay off the bond’s principal before its maturity date.
- Bond Call: When an issuer pays off the principal of the bond before the determined termination or maturity date.
- Callable Bond: A type of bond that allows the issuer new options, including the right to repay the principal, before the bond’s maturity date.
Sources for More Information
- Investopedia: A comprehensive resource for all kinds of financial terms and information.
- Morningstar: A respected provider of independent investment research.
- Zacks: A finance-focused website that delivers an extensive collection of stock investment research and analysis.
- U.S. Securities and Exchange Commission: The U.S. government’s official site for all securities-related information.
