Financial Industry Regulatory Authority (FINRA) Practice Exam

What type of bonds are most likely to expose holders to call risk when interest rates are falling?

1. All callable bonds

2. Callable bonds with lower coupons

3. Callable bonds with higher coupons

4. Bonds that are not callable

The correct answer is: Callable bonds with higher coupons

Callable bonds are designed to give the issuer the right to redeem the bond before its maturity date, usually at a specified call price. This feature is particularly relevant when interest rates are falling. In a declining interest rate environment, issuers may find it beneficial to call their higher coupon bonds to reissue new bonds at lower interest rates, thus saving on interest expenses. Callable bonds with higher coupons are most susceptible to call risk because they offer greater interest payments compared to lower coupon bonds. If interest rates fall, the issuer would want to take advantage of the lower rates and eliminate their obligation to pay those higher coupons. Consequently, the likelihood of the bond being called increases, leaving the holder to reinvest the called amount often at lower prevailing rates. In contrast, callable bonds with lower coupons do not present as much call risk because the incentive for issuers to call them is decreased—there isn't a significant financial benefit to the issuer in calling a lower-yielding bond when they can just continue paying the existing interest. Bonds that are not callable inherently do not carry any call risk at all, as the issuer does not have the option to redeem them early.