Call Risk

Call risk on a corporate bond is greatest when interest rates:

1. A.RiseRising rates make an outstanding low-coupon bond cheap financing — the issuer keeps it.
2. B.Remain unchanged for an extended periodStable rates give the issuer no refinancing incentive.
3. C.FallCorrect. Issuers refinance when rates drop, so calls cluster in falling-rate markets.
4. D.Become more volatile in either directionVolatility alone does not drive calls; the direction of rates does.

Why: Issuers call bonds to refinance at cheaper rates, so calls cluster when rates FALL. The holder loses a high coupon and must reinvest the proceeds at the new lower rates.

A client owns a callable corporate bond purchased at a premium. Rates fall and the issuer calls the bond. Which statement best describes what has happened to her?

1. A.The issuer defaulted on its obligation, so the client has suffered credit risk.Wrong. Exercising a contractual right is the opposite of a default, and the issuer paid exactly what it promised.
2. B.The client loses an above-market coupon and must reinvest at lower rates.Correct. Issuers call when they can refinance more cheaply, which is exactly when the holder least wants the cash back.
3. C.The client benefits, because a call is exercised only when a bond is worth less.Wrong. The call comes when the bond has become valuable to the holder, which is why the issuer wants it retired.
4. D.The client is unaffected, because the call price was disclosed at issuance.Wrong. Disclosure at issuance explains why the call was permitted, not why the holder is worse off for it.

Why: A call provision lets the issuer retire the bond early, and issuers exercise it when rates have fallen far enough to refinance at a lower coupon. From the holder's side the timing is uniformly unfavorable: the attractive above-market coupon disappears and the proceeds can be reinvested only at the new lower rates. The exposure is closely related to reinvestment risk and is driven by market-wide rate moves rather than by anything peculiar to the issuer. A holder who wants to avoid it should seek call protection or buy non-callable issues.

An investor owns a callable 7 percent corporate bond. Market interest rates have fallen sharply and comparable new issues now pay 4 percent. The investor's most immediate concern should be...

1. A.A sharp decline in the bond's market priceFalling rates raise bond prices. This reverses the inverse price-yield relationship.
2. B.The coupon being reset downward from 7 percent to 4 percentA fixed coupon cannot be reset. The issuer's only route to the lower rate is to call the bond and reissue.
3. C.The issuer calling the bond, forcing her to reinvest the proceeds at roughly 4 percentCorrect. Call risk and reinvestment risk arrive together when rates drop below the coupon.
4. D.The issuer defaulting because it can no longer afford the 7 percent couponA lower-rate environment generally eases an issuer's financing burden. Nothing in the facts suggests credit deterioration.

Why: Falling rates make it economical for the issuer to call the 7 percent bond and refinance at 4 percent. The investor loses the above-market income stream and must reinvest the proceeds at the lower prevailing rate, which is call risk combined with reinvestment risk.

A client owns a 6 percent callable corporate bond. Rates fall to 3 percent and the issuer calls the bond. The client faces the combined effect of:

1. A.Credit risk and default riskThe issuer paid in full — a call is the opposite of a default.
2. B.Call risk and reinvestment riskCorrect. The call ends the high coupon and the proceeds must be reinvested at lower rates.
3. C.Liquidity risk and timing riskShe was not trying to sell, and the redemption was the issuer's decision, not her market timing.
4. D.Interest-rate risk and extension riskBoth are rising-rate concerns; rates fell here.

Why: The call itself is call risk, and being forced to redeploy the returned principal into a 3 percent market is reinvestment risk. The two travel together in a falling-rate environment.