Fixed Income Investments - Call and Prepayment Risk
Call and prepayment risk is concerned with the holders having their bonds paid off earlier than the maturity date. This is due to decreasing marker rates, which cause the issuer to call the bonds. It can also occur when the borrowers in a MBS or ABS refinance or pay off their debt earlier than the stated maturity date.
Disadvantages of Investing in Bonds that are Callable or Prepayable
1. It is difficult to develop and forecast the cash flows for the security because of the possible early redemption of the bond.
2. The reinvestment risk is another disadvantage. As rates decrease and bond are called or prepaid, investors will not be able to invest their proceeds at the old rates and will have to use new, lower market rates to put their cash to work.
3. Price compression is the final disadvantage for investors. When rates decline there is a greater chance that the issuer will call the bonds. This compresses or holds the bond at its call price while bonds without this option will continue to increase in market value as rates continue to decrease.