Call and Prepayment Risk

Call and prepayment risk is concerned with the holders having their bonds paid off earlier than the maturity date. This is due to decreasing marker rates, which cause the issuer to call the bonds. It can also occur when the borrowers in a MBS or ABS refinance or pay off their debt earlier than the stated maturity date.

Disadvantages of Investing in Bonds that are Callable or Prepayable

1.It is difficult to develop and forecast the cash flows for the security because of the possible early redemption of the bond.

2. The reinvestment risk is another disadvantage. As rates decrease and bond are called or prepaid, investors will not be able to invest their proceeds at the old rates and will have to use new, lower market rates to put their cash to work.

3.Price compression is the final disadvantage for investors. When rates decline there is a greater chance that the issuer will call the bonds. This compresses or holds the bond at its call price while bonds without this option will continue to increase in market value as rates continue to decrease.

Reference: http://www.investopedia.com/exam-guide/cfa-level-1/fixed-income-investments/call-prepayment-risk.asp

Interest rate Risk

Interest rate risk is concerned with a decline in the price of a bond or a portfolio of bonds due to an increase in market rates. As rates increase, bond prices decline and vice versa.

The features of a bond affect the bond’s interest rate in the following ways:

•Maturity – The longer the maturity of the bond, the more sensitive it is to interest rate movements. The reason for this effect is that more cash flows will be affected over a longer period of time.

•Coupon Rates – Lower coupon rates are more sensitive to interest rates. Why? If your bond is paying 4% and rates are in an upward swing, the difference in the market yield and your yield will continue to widen, which will push your bond values down.

•Embedded Options – As interest rates decline the value of the option becomes more valuable to the issuing company. The price will increase as rates decline but will be held at the call or redemption price. This is because as rates decline it will become more likely that the issuer will call the bonds and that the holder will only receive the call price and not a true market price. Likewise, when rates rise the price will not drop as much because the option will maintain some sort of value when compared to a bond with no options.

Reference: http://www.investopedia.com/exam-guide/cfa-level-1/fixed-income-investments/interest-rate-risk.asp#axzz1giDcOnzS

Image Reference: http://www.rediff.com/cms/print.jsp?docpath=//money/2009/feb/10rbi-how-to-make-money-when-rbi-cuts-rates.htm