Call risk: Meaning, Criticisms & Real-World Uses

What Is Call Risk?

Call risk is the potential disadvantage faced by an investor in a callable bond (a type of debt security) that the bond's issuer will redeem the bond before its scheduled maturity date. This risk primarily arises when prevailing interest rates decline, making it advantageous for the issuer to refinance their debt at a lower coupon rate. Callable bonds are part of the broader fixed income market, where investors typically seek steady income streams. When a bond is "called," the investor receives their principal back, often with a small call premium, but loses the future interest payments they expected to receive.

History and Origin

The concept of callability in bonds emerged as a mechanism for issuers to manage their long-term debt obligations, particularly in an environment of fluctuating interest rates. Early academic discussions around callable bonds often centered on their role in helping alleviate agency conflicts or problems of asymmetric information between bondholders and shareholders¹¹. As financial markets evolved, corporations increasingly utilized callable bonds to gain flexibility. By the late 1990s, the issuance of callable bonds by nonfinancial corporations saw a significant increase, with over 90% of bonds issued by nonfinancial corporations in a notable sample containing call provisions in the latter half of the 2010s¹⁰. This trend reflected issuers' desire to adapt to changing economic conditions and potentially lower borrowing costs. Callable bonds essentially provide the issuer with an embedded option to repurchase the bond, allowing them to refinance at a more favorable rate if market conditions change⁹.

Key Takeaways

Call risk is the risk that a callable bond will be redeemed by its issuer before its stated maturity.
This risk is most prevalent when market interest rates fall, incentivizing the issuer to refinance at a lower cost.
Investors in callable bonds typically receive a higher yield compared to non-callable bonds to compensate for call risk.
The primary consequence of call risk for investors is reinvestment risk, where they must reinvest their principal at potentially lower prevailing interest rates.
Callable bonds exhibit different price behavior than non-callable bonds, with their price appreciation being limited as interest rates decline.

Interpreting Call Risk

Call risk is interpreted as the potential for an investor to have their callable bond redeemed prematurely by the issuer. This risk is inversely related to market interest rates; when rates decline, the likelihood of a bond being called increases. For investors, understanding call risk means recognizing that their expected income stream from the bond could be cut short.

The sensitivity of callable bonds to interest rate changes is unique. While the price of a non-callable bond generally increases as interest rates fall, the price appreciation of a callable bond is capped at or near its call price. This phenomenon is known as price compression, where the bond's market value becomes less sensitive to further decreases in yields once the call option becomes valuable to the issuer⁸. This implies that if an investor bought a callable bond at a premium and it is called, they might not realize the expected capital gains.

Hypothetical Example

Consider an investor, Sarah, who purchases a 10-year, $1,000 face value corporate bond with a 6% coupon rate, callable after five years at a call premium of 102% of par.

Initial Investment: Sarah invests $1,000 in the bond, expecting to receive $60 in interest annually for 10 years, plus her $1,000 principal back at maturity.
Market Change: After three years, prevailing market interest rates for similar quality bonds drop significantly to 3%.
Issuer Action: The issuing company sees an opportunity to reduce its borrowing costs. Since it can now borrow at 3%, it decides to exercise its call option on Sarah's 6% bond.
The Call: The company calls the bond. Sarah receives her $1,000 principal plus the call premium, totaling $1,020.
Impact of Call Risk: Sarah now has $1,020 to reinvest. However, with market interest rates at 3%, she can no longer find a similar quality bond offering a 6% coupon rate. She is forced to reinvest at a lower rate, leading to a reduction in her expected annual income. This scenario exemplifies the direct impact of call risk.

Practical Applications

Call risk is a significant consideration across various facets of finance:

Bond Investing: For individual investors and institutional managers, assessing call risk is crucial when constructing a fixed income portfolio. While callable bonds offer a higher coupon rate to compensate for this risk, investors must weigh the potential for early redemption against the enhanced yield. Due to call risk, investors might find it challenging to match their original rate of return if the bond is called and they must reinvest the proceeds in a lower interest rate environment⁷.
Corporate Finance: Companies issuing callable corporate bonds strategically utilize the call feature to manage their debt structure. If market interest rates decline, they can call back higher-interest debt and issue new bonds at a lower cost, optimizing their capital structure⁶.
Municipal Finance: Many municipal bonds are also callable. State and local governments use this feature to refinance debt, similar to corporations, especially when interest rates are favorable for lower borrowing costs. These call features are typically disclosed in the bond's offering statement⁵.
Regulatory Disclosure: Regulators, such as the Securities and Exchange Commission (SEC), require clear disclosure of call provisions for debt security offerings. For instance, SEC Rule 15c2-12 mandates continuing disclosure requirements for municipal bond issuers, which include information about terms that affect security holders, such as call features⁴.

Limitations and Criticisms

While callable bonds offer benefits to issuers, they come with distinct limitations and criticisms for investors. The most significant drawback is the aforementioned call risk, which exposes investors to the uncertainty of early redemption. This uncertainty directly affects an investor's ability to project future cash flows from their bond holdings.

Critics argue that the higher coupon rate offered by callable bonds, intended as compensation for call risk, may not always adequately offset the disadvantages, particularly in rapidly declining interest rate environments. When rates drop significantly, the investor faces substantial reinvestment risk, as they are forced to reinvest their principal at a much lower yield ³. Furthermore, the price appreciation of a callable bond is limited compared to a non-callable bond as rates fall, restricting potential capital gains for investors who might want to sell before a call date².

Another criticism points to the complexity introduced by the embedded call option within the bond. This complexity can make valuing callable bonds more challenging than non-callable bonds, requiring more sophisticated financial models to account for the optionality¹.

Call Risk vs. Reinvestment Risk

Call risk and reinvestment risk are closely related but distinct concepts in the context of callable bonds. Call risk specifically refers to the possibility that the issuer will redeem a callable bond before its scheduled maturity date. This decision is typically made when market interest rates decline, allowing the issuer to refinance their debt at a lower coupon rate.

In contrast, reinvestment risk is the risk that an investor will not be able to reinvest the proceeds from a called bond (or any maturing or coupon payment) at a yield as high as the original investment. Call risk is a cause that often leads to reinvestment risk. If a bond is called due to falling interest rates, the investor receives their principal back, but then faces reinvestment risk as they search for new investment opportunities in a lower interest rate environment. Without call risk, the investor would continue to receive the higher coupon payments until maturity, thus avoiding the immediate manifestation of reinvestment risk associated with premature redemption.

FAQs

What types of bonds have call risk?

Corporate bonds and municipal bonds commonly feature call provisions, subjecting them to call risk. Treasury bonds are generally non-callable, though exceptions have existed in the past.

Why do companies issue callable bonds if it creates risk for investors?

Companies issue callable bonds to gain flexibility in managing their debt. If interest rates fall, the issuer can call the bond and issue new debt at a lower coupon rate, saving on interest expenses. To compensate investors for this potential early redemption, callable bonds typically offer a higher yield than comparable non-callable bonds.

Can an investor profit from a bond being called?

While a called bond means an investor receives their principal back (often with a small call premium), they typically do not "profit" in the sense of capital appreciation beyond the call price. The main financial impact for the investor is usually the challenge of reinvesting their funds at a comparable yield in a lower interest rate environment, which leads to reinvestment risk.

Is call risk always a disadvantage?

For the investor, call risk is generally considered a disadvantage because it introduces uncertainty about the investment horizon and income stream. However, for the issuer, the call feature is an advantage, allowing them to manage their borrowing costs dynamically. The higher initial coupon rate offered by callable bonds is the trade-off for investors assuming this risk.