Call risk
The risk that a bond is called — redeemed by the issuer before maturity. Most prevalent when interest rates fall, and it usually goes hand in hand with reinvestment risk.
In plain language
An investor buys a bond expecting a certain coupon for a certain number of years. Some bonds give the issuer the right to cut that short and repay the money early — to call the bond. The possibility that this happens is call risk.
The issuer does not call bonds at random. It calls them when doing so saves it money, and that is when interest rates have fallen: the company redeems the old, higher-coupon bonds and replaces them with new issues at lower rates. So call risk tends to bite at exactly the wrong moment for the investor. The high coupon disappears, the principal comes back early, and the only place to put it is a market paying less.
That last step is why the workbook says call risk usually goes hand in hand with reinvestment risk.
How it works
The workbook's three statements (Chapter 12).
- Call risk is specific to bond issues and refers to the possibility that a debt security will be called prior to its maturity.
- It usually goes hand in hand with reinvestment risk.
- It is most prevalent when interest rates are falling, as companies trying to save money redeem bond issues with higher coupons and replace them with issues at lower interest rates.
Why falling rates make it worse — the workbook's own mechanics.
| When rates fall | What the workbook says | Effect on a callable bond holder |
|---|---|---|
| Bond prices | Market price and interest rates are inversely related — when rates fall, bond prices increase (Chapter 3) | The gain is available only while the bond is outstanding; a called bond is simply repaid |
| Reinvestment | If interest rates fall, reinvestment risk increases (Chapter 12) | The whole principal, not just the coupons, must now be reinvested at the lower rate |
| Issuer's incentive | Replace higher-coupon issues with lower-rate issues | The call is most likely precisely now |
Where it sits among the risks. Chapter 12 lists call risk after liquidity risk and immediately before reinvestment risk. It sits apart from credit risk, which is about the issuer being unable to pay; call risk arises when the issuer pays early, by choice.
A worked example
Illustrative figures. Farhan holds Rs 10,00,000 face value of a corporate bond with a 9.5% annual coupon and 6 years left to maturity. The bond is callable at par. One year later, market rates on comparable bonds have fallen to 7.5%, and the issuer calls the bond to refinance.
Income he expected for the remaining 5 years:
Rs 10,00,000 × 9.5% = Rs 95,000 a year
Income after reinvesting the returned principal at 7.5%:
Rs 10,00,000 × 7.5% = Rs 75,000 a year
Shortfall = Rs 95,000 − Rs 75,000 = Rs 20,000 a year
Over 5 years (ignoring compounding) = Rs 1,00,000
The issuer's side of the same trade. On Rs 100 crore of these bonds, refinancing at 7.5% saves it 2 percentage points — Rs 2 crore a year of interest. That saving is the reason the call happened, and it is exactly the investor's loss in reverse.
What he misses on price. Had the bond not been callable, falling rates would have pushed its market price up, because price and rates move inversely. Called at par, Farhan receives Rs 10,00,000 and nothing of that rise.
Farhan's issuer did not default. Every rupee promised up to the call was paid. The Rs 1,00,000 is call risk collected through reinvestment risk.
Why NISM asks about it
Chapter 12 (Fundamentals of Risk and Return) defines call risk in its list of investment risks, directly before reinvestment risk. A research analyst writing on a debt issuer, or on a company with callable borrowings, is expected to recognise that a falling-rate scenario helps the issuer and hurts the holder.
Expect the direction (falling rates), the pairing with reinvestment risk, and "specific to bond issues" as True/False or single-choice questions.
Common exam traps
- Falling rates, not rising rates. Call risk is most prevalent when interest rates are falling.
- It is the issuer's choice, not a default. Do not confuse call risk with credit or default risk.
- Specific to bond issues in the workbook's definition — it is not an equity risk.
- Not a call option on an index. Chapter 2's call options give the buyer the right to buy an underlying; call risk is about the issuer redeeming a bond early.
- Call risk and reinvestment risk travel together. A call hands back the whole principal at the moment rates are low.
- Price gains stop at the call. Falling rates lift bond prices, but a called bond is repaid, not sold at the higher price.
- The workbook does not classify call risk in its systematic/unsystematic lists — reinvestment risk is listed as systematic, credit and liquidity risk as unsystematic. Do not assume a classification for call risk from this text.
Where this is taught
- Series XV · Chapter 12: Fundamentals of Risk and Returnintroduced here
- Series X-A · Chapter 9: Investing in Fixed Income Securitiesintroduced here
Related terms
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Interest rate riskThe risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
- Reinvestment riskThe risk that the coupons or other intermediate cash flows from an investment have to be put back to work at a lower rate than the original investment earned, pulling the total return below the promised yield.
- Yield to MaturityThe single discount rate at which a bond's future coupons and redemption amount add up to exactly its market price today — the return you actually earn if you hold it to maturity.
- Callable bondA bond that the issuer may redeem before its original maturity date — typically exercised when interest rates fall, leaving the investor to reinvest at lower rates.
- Domestic bondA bond issued by an authorised entity of a country, in the bond market of its own home country, and denominated in its own home currency.