DEFINITION of Call Risk
Call risk is the risk faced by a holder of a callable bond that a bond issuer will take advantage of the callable bond feature and redeem the issue prior to maturity. This means the bondholder will receive payment on the value of the bond and, in most cases, will be reinvesting in a less favorable environment (one with a lower interest rate).
BREAKING DOWN Call Risk
A callable bond is one that can be redeemed prior to its maturity date. The bond has an embedded option that is similar to a call option, giving the issuer the right to call the bond before it matures. When interest rates drop in the market, bond issuers seek to take advantage of the lower rates by redeeming the outstanding bonds and reissuing at a lower financing rate. However, bondholders are at a disadvantage given that once a bond is called, interest payments stop being made on the retired bond. To protect investors from having their bonds redeemed too early, trust indentures, which are created at the time of issuance, include a call protection clause.
The call protection is the period of time during which a bond cannot be redeemed. After the call protection expires, the date on which the issuer can call the bonds is referred to as the first call date. Subsequent call dates are also highlighted in the trust indenture. The issuer may or may not redeem the bonds, depending on the interest rate environment. The likelihood of the bond being retired on any of the call dates presents a call risk to the bondholders.
For example, a callable bond is issued with a coupon rate of 5% and has a maturity of 10 years. The call protection period is four years, which means that the issuer cannot call the bonds for the first four years of the bond’s life regardless of how interest rates change in the economy. After the call protection period ends, bondholders are exposed to the risk that the bonds may be paid off if interest rates drop below 5%.
If interest rates have declined since it first issued the bonds, issuers will call the bond once it becomes callable and will create a new issue at a lower rate. It may be difficult, if not impossible, for bond investors to find other investments with returns as high as the refunded bonds. Investors will, therefore, lose out on the high rate of their bonds and will have to invest in a lower rate environment. This reinvestment at a lower interest rate is referred to as reinvestment risk. Therefore, investors exposed to call risk are also exposed to reinvestment risk.