Bond Features and Risks

Bond features such as call provisions, put provisions, and sinking funds affect both the risk profile and attractiveness of a bond. Understanding these features and the various risks associated with bonds is essential for Series 7 representatives.

Call Provisions

A call provision gives the issuer the right (but not obligation) to redeem the bond before maturity at a specified price.

Why Issuers Call Bonds

Issuers typically call bonds when interest rates fall. By calling outstanding bonds with higher coupon rates, they can issue new bonds at lower rates, reducing borrowing costs—similar to refinancing a mortgage.

Call Features

Example: A bond with a 5-year call protection cannot be called during the first 5 years. After that, the issuer may call it at $1,050 (par + $50 call premium).

Impact on Investors

Call provisions benefit issuers but create risk for investors:

• Investors lose a high-yielding investment when rates fall
• Must reinvest returned principal at lower market rates
• Limits the bond's price appreciation potential

Compensation: Callable bonds typically offer higher coupon rates than non-callable bonds to compensate investors for call risk.

Put Provisions

A put provision gives the bondholder the right to sell the bond back to the issuer at par value before maturity.

Benefits for Investors

Put provisions protect bondholders when interest rates rise:

• Bondholder can "put" the bond back at par
• Reinvest proceeds in new higher-yielding bonds
• Limits downside price risk

Trade-off: Putable bonds typically offer lower coupon rates because the put feature benefits the investor.

Sinking Fund Provisions

A sinking fund requires the issuer to retire a portion of the bond issue periodically before maturity.

How Sinking Funds Work

The issuer may:

• Purchase bonds in the open market (if trading below par)
• Call bonds by lottery at par (if trading above par)

Sinking Fund Effects

For investors:

• Reduces default risk (issuer is gradually repaying debt)
• Creates refunding risk—your bond may be called early
• May limit upside price potential

For issuers:

• Demonstrates commitment to debt repayment
• May improve credit rating
• Spreads repayment burden over time

Bond Risks

Interest Rate Risk

Interest rate risk is the risk that changes in market interest rates will affect a bond's market value.

Key relationships:

• When rates rise → bond prices fall
• When rates fall → bond prices rise
• Longer maturities = greater interest rate risk
• Lower coupon rates = greater interest rate sensitivity

Duration measures a bond's sensitivity to interest rate changes. Higher duration means greater price volatility.

Credit Risk (Default Risk)

Credit risk is the risk that the issuer will fail to make interest or principal payments.

Factors affecting credit risk:

• Issuer's financial strength
• Economic conditions
• Industry factors
• Credit rating changes

Credit spread is the difference between a corporate bond's yield and a comparable Treasury yield. Wider spreads indicate higher perceived credit risk.

Reinvestment Risk

Reinvestment risk is the risk that interest payments or returned principal cannot be reinvested at the same rate of return.

When reinvestment risk is highest:

• Interest rates are falling
• Bonds have high coupon rates
• Bonds are callable
• Bonds have sinking fund provisions

Zero-coupon bonds have no reinvestment risk because there are no periodic interest payments to reinvest.

Call Risk

Call risk is a specific form of reinvestment risk. When a bond is called:

• Investor receives principal back early
• Must reinvest at current (usually lower) rates
• Loses remaining scheduled interest payments

Call risk is highest for premium bonds because issuers are most likely to refinance when rates drop significantly.

Inflation Risk (Purchasing Power Risk)

Inflation risk is the risk that inflation will erode the real value of the bond's fixed payments.

Fixed-rate bonds are especially vulnerable because:

• Interest payments don't increase with inflation
• Principal repaid at maturity has less purchasing power
• Longer-term bonds have greater inflation risk

Treasury Inflation-Protected Securities (TIPS) protect against inflation risk by adjusting principal based on the Consumer Price Index.

Liquidity Risk

Liquidity risk is the risk of difficulty selling a bond at a fair price.

More liquid:

• Treasury securities
• Large corporate issues
• Recently issued bonds

Less liquid:

• Municipal bonds
• Smaller corporate issues
• High-yield bonds

Risk Summary Table

On the Exam

The Series 7 exam frequently tests:

• Understanding call provisions and who they benefit (issuer)
• Recognizing that call risk leads to reinvestment risk
• Knowing that zero-coupon bonds have no reinvestment risk
• Factors that increase interest rate risk (longer maturity, lower coupon)