"Call Risk -- What is It?"

call risk management benefits

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This is the bond's version of repayment risk. Many bonds contain a provision allowing the issuing entity to call the bond. Which means that they pay you back your principal even though the time period is not over.

Why would they do that? Because interest rates have gone down so much that they don't want to continue to pay you the older, higher rate of interest.

In the early 1980s, interest rates reached 20%. If you bought a 30 year bond paying 20% in 1982, you got a sweet deal.

Call Risk Means You May Get Your Money Back Too Soon

But if it the bond had a call provision, then the company would have given you your money back sooner than you expected (or wanted), when interest rates went down

It's the equivalent of you refinancing your mortgage when interest rates go down. Why would you continue to pay 8% if you can refinance and get a 5% mortgage?

Companies think the same way.

One way to alleviate this risk is simply to read the fine print before you buy a bond and refuse to buy any bonds with call provisions.

But that's not the smart way -- because you shouldn't even be buying individual bonds.

You should diversify by letting a bond mutual fund do the hard work of choosing bonds to buy and sell. If any of the bonds held by the fund are called away, you won't notice. It'll simply be reflected in the overall performance of the fund. Since the fund manager will be diversifying to reduce risk, nothing that happens with one type of bond should greatly affect the entire fund.

Next: Inflation, or loss of purchasing power risk.

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