What Is Call Risk?
Call risk is the risk that a bond issuer will recover a callable bond prior to maturity. This means the bondholder will receive payment on the value of the bond and, much of the time, will be reinvesting in a less ideal environment — one with a lower interest rate.
Understanding Call Risk
A callable bond is one that can be reclaimed prior to its maturity date. The bond has a embedded option that is like a call option, giving the issuer the right to call the bond before it develops. At the point when interest rates drop in the market, bond issuers try to exploit the lower rates by recovering the outstanding bonds and reissuing at a lower financing rate.
Call protection clauses assist with shielding investors from call risk by keeping an issuer from calling the bond over a set period of time.
Calling a bond puts bondholders in a difficult spot, where when a bond is called, interest payments stop being made on the retired bond. To safeguard investors from having their bonds recovered too early, trust indentures, which are made at the hour of issuance, incorporate a call protection clause.
The call protection is the period of time during which a bond can't be recovered. After the call protection lapses, the date on which the issuer can call the bonds is alluded to as the first call date. Subsequent call dates are likewise highlighted in the trust indenture. The issuer could conceivably reclaim the bonds, contingent upon the interest rate environment. The probability of the bond being retired on any of the call dates presents a call risk to the bondholders.
Illustration of Call Risk
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, and that means the issuer can't call the bonds for the initial four years of the bond's life paying little heed to how interest rates change. After the call protection period closes, bondholders are presented to the risk that the bonds might be paid off assuming interest rates drop below 5%.
In the event that interest rates have declined since the bonds were first issued, issuers will call the bond once it becomes callable and will make another issue at a lower rate. It could be troublesome, in the event that certainly feasible, for bond investors to track down different investments with returns as high as the refunded bonds. Investors will, in this manner, miss out on the high rate of their bonds and should invest in a lower rate environment. This reinvestment at a lower interest rate is alluded to as reinvestment risk. Subsequently, investors presented to call risk are likewise presented to reinvestment risk.
- Call risk is like reinvestment risk, where the investor risks having to reinvest at a lower interest rate.
- Call risk is the risk that a callable bond will be "called." The risk connects with a bond being called before maturity.
- Callable bonds are likened to call options, where the issuer has the privilege to call the bond before maturity.