What it means
The mechanics are straightforward. The issuer exercises a contractual right, you receive the call price plus accrued interest, and the bond disappears from your portfolio whether or not the timing suits you.
What makes it a genuine risk rather than an inconvenience is the correlation with the rate environment. Calls cluster in falling rate markets, so a portfolio of callable bonds tends to lose its highest yielding holdings precisely when nothing comparable is available to buy.
There is a second effect called negative convexity. When rates fall, a normal bond rises steadily in price, but a callable bond's price stalls near its call price because everyone knows the issuer will redeem it, so the investor gets limited upside while still taking the full downside when rates rise.
Investors are compensated for this through a higher coupon. The difference between a callable bond's yield and that of an otherwise identical non-callable bond is effectively the price the issuer pays for the option to call.
Managing call risk is mostly about measurement and diversification. Analysts value callable bonds using yield to worst rather than yield to maturity, stagger call dates across a portfolio, and avoid paying large premiums for bonds trading well above their next call price.
In practice
Real-world examples.
Example
A retiree built a portfolio of callable corporate bonds yielding 6.8% to fund living costs. When rates fell, eleven of the fourteen holdings were called within eighteen months, and the replacement portfolio yielded 4.1%, cutting annual income by nearly 40%.
Example
A municipal bond fund reports strong performance during a rate rally but underperforms an equivalent non-callable index. The manager explains that call risk capped the price appreciation of most of the portfolio near the various call prices.
Example
A treasury team invests surplus cash in agency notes with a one year call feature to pick up an extra 0.5% of yield. The notes are called after seven months, and the team has to redeploy the money at a lower rate, wiping out most of the extra yield it had captured.
Formula
Calculation
Annual income shortfall = original income - income after reinvestment
Total shortfall over the remaining term = annual shortfall x years remaining
An investor holds $500,000 of bonds paying a 7% coupon, producing $500,000 x 7% = $35,000 a year. The bonds still had six years to run when the issuer called them at 102.
Prevailing yields on comparable new bonds have fallen to 4.25%, so the reinvested proceeds generate roughly $500,000 x 4.25% = $21,250 a year. The annual shortfall is $35,000 - $21,250 = $13,750.
Across the six years the investor expected to hold the bonds, that adds up to $13,750 x 6 = $82,500 of lost income. The call premium of 2% x $500,000 = $10,000 offsets part of it, leaving a net economic cost of $82,500 - $10,000 = $72,500, which is what call risk actually costs when it materialises.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Havelock Trust, an invented family investment office, held $4,000,000 of callable bonds averaging a 7.2% coupon and paying out $288,000 a year to beneficiaries. The trustees regarded the income as dependable because the bonds had eight years left to maturity.
Over an eighteen month period in the fictional scenario, issuers called $3,200,000 of the portfolio as market yields dropped. Reinvesting at 4.4% produced $3,200,000 x 4.4% = $140,800 a year against the $230,400 those bonds had been paying, a fall of $89,600 in annual distributions.
The trustees had never modelled a call scenario, having focused entirely on credit quality. Afterwards they rewrote the investment policy to require yield to worst reporting, a maximum price above the next call price, and a cap on how much of the portfolio could become callable in any single year.
Watch out
Common mistakes.
- Budgeting future income from a callable bond portfolio using yield to maturity, which assumes the calls never happen.
- Chasing the higher coupon on callable bonds without recognising that the extra yield is payment for giving the issuer an option.
- Paying a large premium for a callable bond trading well above its next call price, which locks in a capital loss if it is redeemed.
Questions
People also ask.
Is call risk the same as reinvestment risk?
They are closely linked, since a call forces reinvestment, but reinvestment risk also applies to maturing bonds and coupon payments that must be redeployed.
How can an investor reduce call risk?
By favouring bonds with long call protection, spreading call dates across years, and holding some non-callable bonds so not every holding can disappear at once.
Does call risk affect share investors?
Not directly for ordinary shares, though holders of callable preferred shares face the same problem, since those can be redeemed at a set price once the protected period ends.
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