Call Risk

Call Risk is the danger that a bond or other fixed-income security will be redeemed (or “called”) by its issuer before its scheduled maturity date. Imagine you've loaned money to a company via a bond, and they've promised to pay you 5% interest for the next 10 years. But if interest rates in the market drop to 3%, the company might find it cheaper to pay you back early, get rid of its expensive 5% debt, and issue new bonds at the lower 3% rate. For the issuer, this is a smart financial move. For you, the investor, it’s a major headache. You get your principal back sooner than expected, but now you have to reinvest that money in a lower-interest-rate environment, leading to a loss of future income. This is a classic example of reinvestment risk, a close cousin of call risk.

Being on the receiving end of a “call” can feel like your favorite TV show getting canceled mid-season—it's an unwelcome and abrupt end to a good thing. For an investor, especially one relying on a steady income stream, the consequences are very real.

• Loss of Future Income: The primary pain point is the loss of the predictable, higher-interest coupon payments you were counting on. If you owned a bond paying you $500 a year for a decade, a call after year three means you lose out on seven years of that reliable income.
• Unfavorable Reinvestment: You now have a lump sum of cash to reinvest. But the very reason your bond was called is that interest rates have fallen. You're forced to shop for new investments in a market offering lower returns, diminishing your overall earnings potential. It’s like a landlord canceling your cheap, long-term lease, forcing you to find a new apartment at today's much higher market rates.
• Capped Price Appreciation: Call risk puts a ceiling on how much your bond's price can increase. In a falling-rate environment, a regular (non-callable) bond's price will rise significantly. However, a callable bond's price will struggle to rise much above its call price (the price the issuer pays to redeem it). Why? Because savvy market participants know that if the price gets too high, the issuer will simply call the bond, and no one wants to pay $1,100 for a bond that could be snatched away from them for $1,010 tomorrow.

While you can't stop a company from calling its bonds, you can certainly be prepared. A smart value investor does their homework to avoid nasty surprises.

The terms of any call feature are never a secret; they are clearly laid out in the bond prospectus. This document is your best friend. When you analyze a bond, look specifically for the call provision section, which will detail:

• The Call Price: This is the price the issuer must pay to redeem the bond. It is often set at the bond's par value (usually $1,000) or slightly higher. The amount paid above par is known as a call premium, which serves as a small compensation to the investor for the inconvenience.
• The Call Schedule: Bonds often can't be called immediately after they are issued. They may have a call protection period, for example, the first 5 or 10 years of the bond's life, during which the issuer cannot call it. A longer protection period is obviously better for the investor.

Before buying a bond, don't just look at the advertised Yield to Maturity (YTM), which assumes the bond is held until its final maturity date. Instead, you must calculate the Yield to Call (YTC). Yield to Call (YTC) is the total return you would receive if you bought the bond today and it was called by the issuer at the earliest possible date. A prudent investor always compares YTM and YTC and bases their decision on the lower of the two figures. This is known as the “yield to worst.” If a bond is trading for more than its call price, its YTC could even be negative, meaning you are guaranteed to lose money if the bond is called—a situation a value investor avoids at all costs. By focusing on the worst-case scenario, you ensure you are being adequately compensated for the risks you are taking, including call risk.