Call Risk

Call risk is the probability that a bond issuer will exercise a call option — repaying the bond before its stated maturity — typically when interest rates fall and the issuer can refinance at lower rates. Call risk is a form of prepayment-risk specific to corporate and municipal bonds.

How the call option works

When you buy a corporate bond yielding 5%, the issuer typically retains the right to call the bond — repay it in full — after a call-protection period, often 5 years.

If interest rates subsequently fall to 3%, the issuer’s incentive is clear: refinance the 5% bond with a new 3% bond, saving 2% per year. The issuer exercises this option (calls the bond). You receive your principal back — maybe at 101 or 102 (a small premium) — but you must reinvest the proceeds in a 3% market. You lose the stream of 5% coupons.

This is call risk. It is the risk that you bought a high-coupon bond expecting to receive that coupon for years, but the issuer takes it away from you when it becomes favorable to do so.

Call risk is asymmetric

Like prepayment-risk, call risk is asymmetric. When rates fall, you hope your high-coupon bond rises in value (which it does, initially). But then it gets called away at par (or a small premium like 101), capping your gain. When rates rise, the bond falls in value (you lose), but it does not get called — the issuer holds the low coupon, which is now valuable. You lose both ways.

The call option is valuable to the issuer and thus comes out of the bondholder’s pocket. This is why callable bonds yield more than non-callable bonds of the same maturity and credit quality. A non-callable bond might yield 4.5%; a callable bond of the same issuer might yield 5.5%. That extra 1% compensates you for the risk that the bond is called when rates fall.

Call protection and call dates

To limit the damage, bonds typically come with call protection — a period (say, 5 years) during which the issuer cannot call the bond. After the protection period ends, the bond becomes callable on any interest payment date.

A call schedule specifies the call prices (e.g., 101, 100.5, par) for different call dates. Most bonds have a call premium to soften the blow: the issuer must pay 101 (instead of par, 100) if calling in year 6, declining to par in later years.

Call protection gives you peace of mind for the protected period, but once it expires, the bond can be called anytime. If rates fall dramatically a few years into the call-protected period, you will be dreading the call protection expiration.

Who bears call risk

Corporate bondholders bear the most direct call risk. Most corporate bonds are callable.

Municipal bondholders also bear call risk; municipal bonds are frequently callable.

US Treasury bondholders are largely exempt — most Treasury bonds are non-callable (though some older Treasuries have been callable, and some agencies have call options).

Mortgage investors bear a form of call risk through mortgagees’ refinancing option, which is a prepayment right rather than a call, but the effect is similar.

Managing call risk

Investors concerned about call risk can:

• Avoid callable bonds. Hold non-callable bonds, Treasuries, or bonds in their call-protected period. The yield will be lower, but call risk is eliminated.

• Buy during call protection. When a callable bond has several years left of call protection and yields are attractive, the call risk is dormant.

• Use yield to call (YTC). Instead of yield to maturity (YTM), calculate the yield assuming the bond is called at the earliest call date. This is the more conservative (lower) yield. If you are satisfied with the YTC, you can accept call risk.

• Calculate option-adjusted spread (OAS). This metric adjusts for the embedded call option, allowing comparison across callable bonds and with non-callable bonds. A higher OAS indicates more valuable call option (more risk to the bondholder).

• Accept the higher yield. Many investors simply hold callable bonds for the extra yield and accept that they may be called. Over time, the extra yield compensates for the call risk.

For individual investors, a practical approach is to diversify across bond types and maturities, understand that callable bonds yield more for a reason, and avoid concentration in any single callable bond.

See also