What is Call Risk?

Call risk (or prepayment risk) applies to bonds that have call provisions, i.e. the issuers have the option to “call” (prepay) their bonds. The corollary is that the holder is uncertain in respect of the future cash flows on the bond.

Issuers that have a call provision on their paper usually call the paper when the market rate has dropped below the coupon rate. The consequence of this is that the benefits of capital gains are smaller than in the case of option-free bonds, i.e. when rates decline they decline less on callable bonds.

It will be apparent that call bonds are also exposed to reinvestment risk. When a bond is called the investor is left with the problem of investing the proceeds of the called bond in other bonds, the rate on which may be lower than the rate enjoyed on the call bond.