Call Risk is the possibility a bond will be called before the bond has paid out fully or reached maturity. Issuers can call their bonds if the bonds have a call provision. The issuing firm essentially cancels their agreement to pay interest and gives you the par value and a small premium instead. The interest between the call and maturity is lost forever, which reduces total return. You should avoid bonds with call provisions, since call risk only exists with call provisions.
Callable bonds pay higher rates than regular bonds as “compensation” before and after their call date. This actually makes them more likely to be called to save the issuer money paid on interest costs in the future. Issuers call bonds in response to interest rates and interest costs. They try to reduce interest paid to bond owners.
The problem comes when interest rates fall. If interest rates fall, bonds with a higher interest rate than the current rate increase in value. Firms can now issue bonds with interest rates below the old rate.
If a firm is paying interest on callable bonds at current interest rates, when the interest rate falls they can simply call the old bonds and issue new debt at the lower interest rates. This will save them money on interest costs in the future. Callable bonds with interest rates above current rates are highly likely to be called. Firms are wise to call the bonds. By calling bonds they can save money which they spend elsewhere or reinvest.
If interest rates rise, existing callable bonds decrease in value. Firms must issue bonds above the interest rate or they will be ignored by buyers in the market, so investors will be more interested in buying new bonds. Investors have no desire to earn interest rates lower than what they can get at equal risk elsewhere in the market. This reduces the price they are willing to pay for your existing callable bonds below higher new interest rates. You’ll have to reduce the price you’re willing to sell the bond until the yield is desirable for buyers.
The problem is that callable bonds expose you to lopsided risk. Your bond will decrease in value if rates rise. If rates fall, your bond may get called before you can benefit from selling them at the increased value. Call risk is an asymmetric risk. You will probably lose if the rates fall, but you’ll be at a disadvantage if rates increase.
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