Call Risk Definition
Call risk is the risk that the bond an investor has invested in will be redeemed by the issuer before its maturity date, thereby raising the risk for the investor as he would have to reinvest the redeemed amount at a much lower rate or in an unfavorable investing market scenario.
Components of Call Risk
Call Risk, as explained earlier, exposes an investor to an unfavorable environment. It has two major components
- Time to Maturity: Call risk is often associated with callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls. providing an option to the issuer to call the bond much before the maturity date. The probability of a bond being called decreases with time as there is less time left for the bond issuer to exercise the option to call the bond.
- Interest Rates: Interest rates are even a bigger factor in call risk as when the interest rates fall, the yield increases, and the issuer will find it profitable to call the bond and restructure the bonds as per the current interest rate cycles, thereby leading to paying lower coupons on the same amount of principal.
Example of Call Risk
The following is the example of call risk.
Suppose a firm reached out to the financial market participants to fund its long-term liabilitiesLong-term LiabilitiesLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). . In the process, the bonds of the firm issue as the management does not want to dilute its equity stake. Let’s suppose the bonds are issued at a coupon rate of 7%. This effectively means that the firm pays out $7 to the bondholders for each $100 invested. The coupon rate of 7% was decided as per the current prevailing rate of 6% (assuming the risk-free rate). Assume that due to changing political and economic scenarios like trade wars and periods of recessions, the interest rates cycle changes, and the yield curveYield CurveThe Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). inverts.
This effectively means that the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk. decreases. For calculation purposes, let’s assume that it drops to 3%. In the case of vanilla bond issued by the firm, it has to still pay 7% even if the new bonds issued are at a much lower rate as the risk-free rate has itself dropped considerably(6% to 3%). The firm is effectively borrowing at a much higher rate, which can have a considerable effect on its cashflows.
Now consider the scenario when the management had issued a callable bond. In that scenario, the firm would have to pay a higher coupon (let’s assume 7.5%) when the risk-free rate is 6%, as the investors would demand a premium even if the credit rating of the firm is high. The advantage that the firm would have by issuing this callable bond is that it can pay back the principal amount to the bondholders much before the maturity date and restructure the debt at a much lower rate (let us say 4%) as the risk-free rate has itself has decreased by 50%.
In the above example, 0.5% (7.5 % – 7 %) is the call risk premium of the callable bond. The following tables summarized the cashflows in both scenarios.
The firm issued a Vanilla bond
The firm had issued a callable bond, and the interest rate cycle changes after 3 years.
Ignoring the change in duration and the time value of moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment. in the interest of simple calculations, we can see the firm has saved at least $ 75 in the pay-out of $ 700 (i.e., more than 10%) across 10 years. For the investor who had invested in scenario 2 (callable bond), the cash flow would have considerably reduced. This is called as call risk and is applicable to the investor of the callable bond.
- An investor invests in a bond because he wants to get a fixed return for a particular duration of time. At the maturity date, when the time to the horizon has completed, the principal value is returned. This is a typical life cycle of a vanilla bond. However, the situation gets a twist if the bond issued is a callable bond. In such a scenario, the issuer of the bond has a right to call the bond, return the principal to the investor much before the maturity date.
- Although the investor has got his money back, he has to reinvest the principal amount to gain the same quantum of returns. This might not be possible because the market situation might be completely different. Most often than not, the interest rates would be low. In economic terms, this is termed as reinvestment riskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity. – the risk that the principal reinvested might not give the same returns as it was initially bound to give.
- The issuer of the callable bond has to pay a premium in addition to the coupon rate as the investors have to carry a call risk and expect to be compensated for the same.
- In terms of calculations, the pay-out of call risk is calculated similarly to the call option as the issuer may or may not call the bond.
Call risk as such itself is not cause of worry to the investor but is the beginning of many more unfavorable and unforeseen situations. It is nothing but reinvestment risk as It exposes the bondholder to an unfavorable investing environment, thereby leading to an unexpected decrease in cashflows and hence the portfolio risk. Although if managed properly, it can help a speculator earn good returns in a considerably short period of time.
This has been a guide to what is call risk and its definition. Here we discuss the example of a call risk along with an explanation and its important points. You can learn more from the following articles –