Call risk is the risk that bonds will be redeemed ("called") by the issuer before they mature. Municipal and corporate bonds are subject to call; Treasuries generally are not. Some older 30-year Treasuries may be callable five years before they mature, but the Treasury no longer issues any callable bonds.
The ability to call bonds protects issuers by enabling them to retire bonds with high coupons and refinance at lower interest rates. Calls are usually bad news for bondholders. A call reduces total return because bonds are called when interest rates are lower than the coupon interest of the bond that is being called. A high interest rate, thought to be "locked in," disappears, and the bondholder is forced to reinvest at lower rates.
If a bond was purchased at par, there is no loss of principal. But if it was purchased at a premium (say for $1,200), an unexpected early call can result in a substantial loss of principal, since bonds are typically redeemed at or close to par. If the $1,200 bond is redeemed at par, then that translates into a $200 loss per bond.
The prospectus spells out call provisions by stipulating both specific call dates and call prices, which are typically somewhat above par. Call provisions differ, depending on the type of bond you are buying. Call provisions for corporates can be obscure. Mortgage-backed securities do not have stipulated call dates, but prepayments constitute a type of call risk.
Never buy a bond without specifically inquiring about the call provisions for that particular bond.
When a bond is offered, the broker should quote not only the yield-to-maturity, but also the yield to the earliest call date (appropriately known as the yield-to-call). Brokers usually quote the yield-to-call for munis, but seldom for corporates. If the coupon rate is a lot higher than the current yield on similar bonds, it is prudent to assume that the bond will be called and to evaluate the bond based on the yield-to-call. If, for example, a broker offers you a bond with an 8% coupon, maturing in 10 years, callable in one year, and yields are now at 6% for similar maturities, you should assume the bond will be called.
Let us note in passing another term that has come into use as an alternate to yield-to-call: yield-to-worst. That is the lowest yield that a bond would earn, under some provision in the indenture, whether that is a call, or a sinking fund provision or even the yield-to-maturity. If you are buying a bond, always inquire about yield-to-worst.
How can you protect yourself against calls?
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