Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksMedium
A portfolio manager is considering investing in a bond that is currently trading at a premium. The bond has a call feature, which allows the issuer to redeem the bond before its maturity date. Which of the following risks is most relevant in this scenario if interest rates decline?
- AInflation Risk
- BDefault Risk
- CLiquidity Risk
- DCall Risk
Show answer & explanationAnswer & explanation
Correct answer: D. Call Risk
Call risk is the risk that a bond, especially one trading at a premium, will be redeemed by the issuer before maturity if interest rates decline. This would force the investor to reinvest the principal at a lower prevailing interest rate.
Why the other options are wrong
- A. Inflation risk is the risk that inflation erodes purchasing power, not the primary concern with a callable bond in declining rates.
- B. Default risk is the risk of the issuer failing to make payments, not directly tied to a call feature or declining rates.
- C. Liquidity risk is the risk of not being able to sell an investment easily, not the main issue with a callable bond in this context.
Call Risk
The risk that a bond will be redeemed by the issuer before its maturity date, typically when interest rates fall, forcing investors to reinvest at lower rates.
- Most relevant for callable bonds trading at a premium
- Occurs when interest rates decline
- Investor loses future higher interest payments
- Reinvestment risk is a direct consequence
Memory trick: Falling rates make the issuer CALL, and your returns FALL.