How it works (Example):
Some bonds are callable, that is, the issuer has the right to call, or buy back all or some of the bonds before they mature. This often happens when interest rate risk rates fall. For example, consider a callable 10-year, 10% coupon bond issued by XYZ Company. Presumably, XYZ Company issued the debt at prevailing market rates. But as time passes, market rates may change. If rates fall to 5% while the bonds are outstanding, XYZ Company would be paying twice the going interest rate. Clearly, this situation costs XYZ Company money, and if it can call the debt and reissue it at the lower 5% rate, it will probably do so.
Why it Matters:
Call risk leads to reinvestment risk. In our example, XYZ Company's call provision means bondholders no longer have the promise of 10 years of 10% interest payments. So, if XYZ Company does call its bonds, bondholders will receive their principal back (plus a call premium), but then they will have to reinvest that money in a lower interest rate environment. It may then be difficult, if not impossible, to find other investments with returns as high as the XYZ Company bonds.
Ultimately, investors can eliminate call risk by avoiding non-callable bonds. However, if the investor receives enough compensation for call risk, callable bonds may be a great way to generate high returns.