Prepayment Versus Call Feature

Most U.S. Treasury bonds are non-callable—the government cannot redeem them before maturity. However, some government-issued bonds and certain agency securities contain call features, allowing early redemption. Understanding these distinctions is crucial for evaluating call risk and expected returns.

Treasuries are non-callable

U.S. Treasury bonds and notes are issued without call provisions. Once the Treasury sells a 30-year bond, it cannot repurchase it early, even if interest rates drop dramatically. This is a key feature that makes Treasuries transparent and predictable—investors know the bond will remain outstanding until the maturity date.

The absence of a call feature is one reason Treasuries trade at relatively tight spreads compared to corporate bonds or agency securities of similar maturity. Investors value the certainty that they will not have capital returned early and be forced to reinvest at lower rates.

Call features in other government securities

Some agency bonds issued by government-sponsored enterprises (GSEs) like Fannie Mae or Freddie Mac do contain call features. A callable bond gives the issuer the option to redeem the bond before maturity, typically if interest rates have fallen. The issuer exercises the call to refinance at lower rates, much like a homeowner refinancing a mortgage.

From the investor’s perspective, a call is a risk, not an opportunity. If rates fall and the bond’s price rises, the issuer calls it, capping your upside. You get the bond back at the call price (often par), not at the appreciated market value.

Embedded optionality and pricing

A callable bond is economically equivalent to owning a non-callable bond plus having sold a call option to the issuer. The issuer’s ability to call the bond is worth money, so callable bonds trade at lower prices (higher yields) than non-callable bonds of similar maturity and credit quality.

The reduction in yield to account for call risk is called the “option-adjusted spread.” A callable bond yielding 3.5% might be economically equivalent to a non-callable bond yielding 3%, with the 0.5% difference compensating for the embedded call option.

The negative convexity problem

Convexity measures how much a bond’s price acceleration changes as yields shift. Non-callable bonds have positive convexity—as yields fall, prices rise faster and faster; as yields rise, prices fall more slowly. Callable bonds have negative convexity—as yields fall, the call option becomes more valuable and the bond’s price appreciation caps out (the issuer is likely to call it). You lose upside in falling-rate scenarios.

This asymmetry makes callable bonds riskier for investors who expect rates to fall. If you buy a callable agency bond and then the Fed cuts rates sharply, your upside is limited while your downside (if rates rise instead) is unchanged.

Prepayment risk versus call risk

In mortgage-backed securities, prepayment risk is analogous but distinct. Homeowners pay off mortgages early when rates fall and they refinance. The MBS investor loses the upside from price appreciation. Government bonds don’t have borrowers prepaying, but callable agency bonds have the same dynamic: the issuer redeems early when economically advantageous to them, hurting investors.

Valuation adjustments

When comparing callable and non-callable bonds, always use option-adjusted spread (OAS) rather than simple yield spread. OAS accounts for the embedded optionality and gives a truer picture of relative value. A callable bond with a 50 basis-point OAS advantage over a non-callable bond offers genuine extra compensation for the call risk.