Risk Of Call Timing

Many bonds have a clause that enables the issuer to "call all or part of the issued before the maturity date," as was mentioned in the previous piece. If market interest rates fall below the coupon rate, the issuer often retains the right to repurchase the bond at a later date.

The call provision has three drawbacks from the investor's point of view.

1.     Uncertainty surrounds the callable bond's cash flow pattern.

2.     When interest rates decline, the issuer will call the bonds.

3.     Because the price of a callable bond may not climb much above the price at which the issuer may call the bond, the potential for capital appreciation of a bond will be diminished.

The ability of the borrower to call or terminate the bond before to the stated maturity date is inherent in a large number of lengthy treasury and agency bonds, most corporate and municipal bonds, and nearly all mortgage-backed securities. Even while the investor is often rewarded for taking on the call risk through a reduced price or a greater return, it can be difficult to assess if this payment is adequate. Anyhow, the returns from a bond with call risk may differ significantly from those from a non-moldable bond.

The size of this risk relies on the call's numerous factors as well as the state of the market. The relevance of timing risk is sometimes ranked second to interest rate risk by market participants due to how widespread it is in the management of fixed income portfolios.

When it comes to mortgage-backed securities, the cash flow is based on the principal prepayments made by the homeowners in the mortgage pool that acts as the security's collateral. Prepayment risk is the name for the time risk in this scenario. It also contains contraction risk or the chance that, when mortgage interest rates fall, homeowners will prepay all or a portion of their mortgages. However, investors would gain from prepayments if interest rates rose. Extension risk refers to the possibility that prepayments would decline when mortgage interest rates rise. Prepayment risk, which includes contraction risk and extension risk, is what timing risk is known as in the context of montage-backed securities.