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NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Investing in Fixed Income Securities

Which of the following risks is the main concern for a holder of a callable bond when interest rates fall sharply?

The main concern is reinvestment risk. When interest rates fall sharply, an issuer is likely to call the bond and repay early, forcing the investor to reinvest the proceeds at lower prevailing yields than the original coupon.

  1. AReinvestment risk, because the issuer may redeem earlyCorrect
  2. BDefault risk, because coupon payments stop
  3. CInflation risk eliminated by the call feature
  4. DLiquidity risk because the bond becomes non-tradable

Explanation

When rates fall, the issuer is likely to call the bond and refinance more cheaply. The investor gets principal back early and must reinvest at lower yields, which is reinvestment risk. The call does not signal default, nor does it remove inflation risk.

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