2.4 Bond Features and Risks

Call Provisions

A call provision lets the issuer redeem a bond before maturity at a set price. Issuers call when rates fall — they retire high-coupon debt and refinance cheaper, exactly like refinancing a mortgage.

Example: A bond with 5-year call protection cannot be called for 5 years; afterward the issuer may redeem at $1,050 (par + $50 premium). Calls hurt investors: they lose a high-yielding holding, must reinvest at lower rates, and the call price caps upside. To compensate, callable bonds carry higher coupons than otherwise-identical non-callable bonds. Call risk is greatest for premium bonds.

Put Provisions

A put provision lets the bondholder sell the bond back to the issuer at par before maturity. It protects investors when rates rise: put the bond back at par and reinvest at higher rates, which limits downside price risk. Because the feature favors the investor, putable bonds carry lower coupons. Call benefits the issuer; put benefits the investor — a guaranteed exam contrast.

Sinking Fund Provisions

A sinking fund requires the issuer to set aside money to retire part of the issue periodically. The issuer either buys bonds in the open market (when they trade below par) or calls them by lottery at par (when above par). Sinking funds reduce default risk because debt is repaid gradually, but they create refunding/call risk for the holder whose bond may be retired early.

The Six Core Bond Risks

Interest Rate Risk

The risk that rising rates lower a bond's market value. Longer maturity and lower coupon both increase sensitivity; duration quantifies it. A 20-year 4% bond is far more volatile than a 5-year 8% bond.

Credit (Default) Risk

The risk the issuer misses interest or principal. The credit spread — a corporate yield minus a comparable Treasury yield — widens as perceived risk rises. Treasuries are considered free of credit risk.

Reinvestment Risk

The risk that coupons or returned principal cannot be reinvested at the original rate. Highest when rates are falling, coupons are high, and bonds are callable or have sinking funds. Zero-coupon bonds have no reinvestment risk because there are no interim coupons to reinvest — a favorite exam point.

Call Risk

A form of reinvestment risk specific to callable bonds: the investor gets principal back early and must reinvest at lower rates, losing remaining scheduled interest. Greatest for premium bonds when rates drop.

Inflation (Purchasing Power) Risk

The risk that inflation erodes the real value of fixed payments. Worst for long-term, fixed-rate bonds. Treasury Inflation-Protected Securities (TIPS) hedge this by adjusting principal with the Consumer Price Index, so both the inflation-adjusted principal and the semiannual coupon (a fixed rate on rising principal) grow with inflation.

Liquidity (Marketability) Risk

The risk of not selling quickly at a fair price. Treasuries and large, recent corporate issues are highly liquid; small municipal and high-yield issues are less so. Thin markets force a seller to accept a lower price or wait, widening the bid-ask spread the client effectively pays.

Legislative, Political, and Currency Risk

The exam also recognizes secondary risks worth naming. Legislative risk is the chance that a change in law — for example, a cut to a municipal bond's tax exemption — reduces a bond's value. Political (sovereign) risk applies to foreign government bonds whose value can fall with instability. Currency (exchange-rate) risk affects bonds denominated in a foreign currency: even a sound issuer can disappoint a U.S. investor if the foreign currency weakens against the dollar. These rarely dominate a question but appear as distractors and in suitability scenarios for international holdings.

Matching Features and Risks to the Client

The practical skill the exam rewards is connecting a feature to the risk it creates and then to a suitable client. A retiree seeking dependable income dislikes call risk, so a non-callable or putable bond suits her better than a premium callable bond that may be redeemed just as rates fall. An investor worried about inflation over a long horizon is steered toward TIPS. An investor who needs to liquidate on short notice should avoid thinly traded high-yield or small municipal issues. Tie each recommendation back to the client's objective, time horizon, and risk tolerance — the recurring logic behind nearly every features-and-risks question.

Risk Summary

On the Exam

Know who each feature benefits (call = issuer, put = investor), that call risk is a form of reinvestment risk concentrated in premium bonds, that zero-coupon bonds eliminate reinvestment risk, that TIPS hedge inflation, and that longer maturity plus lower coupon maximize interest rate risk.