What Is Call Risk and How Does It Affect Your Investments?

Call risk is a consideration for investors holding certain types of securities. It refers to the possibility that an issuer might redeem a bond or other callable security before its scheduled maturity date. This redemption occurs at the issuer’s discretion, impacting the investor’s anticipated return and investment timeline. While it offers flexibility to the issuer, it introduces challenges for the investor.

Understanding Call Risk

Call risk centers on the concept of a “callable” security, which grants the issuer the right, but not the obligation, to buy back the security from the investor before its stated maturity. This feature is typically embedded in the terms of the security at the time of issuance.

Issuers primarily exercise this option when market interest rates decline significantly below the rate they are paying on existing debt. By calling back higher-interest securities, the issuer can then issue new ones at a lower, more favorable interest rate, similar to how a homeowner might refinance a mortgage to reduce monthly payments. This allows the company to reduce its overall interest expenses, benefiting its financial health.

Investments Susceptible to Call Risk

The primary financial instruments that carry call risk are callable bonds and callable preferred stock. Callable bonds are debt instruments where the issuer can repay the principal and cease interest payments before the bond’s original maturity date. Companies or municipalities issue these bonds to fund projects or operations.

Callable preferred stock is another security susceptible to this risk. Preferred stock pays a fixed dividend, and a call provision allows the issuing company to repurchase shares at a predetermined price after a specific date. Companies might call preferred stock if market interest rates fall, allowing them to issue new shares at a lower dividend rate and reduce their cost of capital.

Investor Implications

The direct impact of call risk on an investor is often termed “reinvestment risk.” This occurs when a called security forces the investor to reinvest principal at a potentially lower prevailing interest rate. If the original security paid a higher interest rate, the investor may struggle to find a comparable investment offering the same yield.

This can lead to a loss of anticipated income, affecting overall returns. For instance, if a bond paying 5% is called when new bonds yield only 3%, the investor loses the opportunity to earn the higher 5% for the remainder of the original term. The investor receives principal back earlier than expected but faces the challenge of generating similar returns in a less favorable interest rate environment.

Identifying Callable Securities

Investors can determine if an investment carries call risk by examining the security’s official documentation. Call provisions are disclosed in the bond prospectus, offering documents, or the terms of the preferred stock. These documents outline the conditions under which the issuer can exercise the call option.

Key terms include the “call date,” which specifies when the issuer can first call the security, and the “call price,” the amount the issuer will pay to redeem it. A “call premium” may also be mentioned, representing an amount paid over face value for early redemption. These terms help investors assess the likelihood and financial implications of a security being called.