In 1986, General Motors issued $1.25 billion in bonds with an 8.5% coupon—generous at the time. But by the early 1990s, interest rates had plummeted. GM was stuck paying top dollar while new issuers borrowed at half the rate. That costly lesson is why today virtually every corporate bond includes call provisions.
Beyond basic bond structure, bonds can include special features that significantly affect their value and behavior. Understanding these features—and the full spectrum of bond risks—is essential for advising clients.
Section 1: Call and Put Features
Why This Section Matters
Call features benefit issuers; put features benefit investors. Understanding which party benefits—and when they'd exercise these features—is essential for advising clients and passing your exam.
Bond Call Features
Think about it from the issuer's perspective: if you borrowed money at 8% and rates dropped to 5%, wouldn't you want to refinance? That's exactly what callable bonds allow. The issuer retires old high-rate debt and issues new bonds at lower rates. It's the corporate equivalent of refinancing your mortgage—except bondholders are on the losing end.
When a bond is callable, the issuer has the right to call (redeem) the bond before it matures. This forces bondholders to sell the bond back. Selling a bond back before maturity is known as redeeming the bond.
The callable bond's issuer doesn't owe any interest after redemption. This is a risk for the bondholder, known as call risk. Issuers typically compensate bondholders for call risk in three ways:
- Higher coupon rate — Callable bonds usually offer higher rates than comparable non-callable bonds
- Call protection period — A period during which the bond cannot be called
- Call premium — An additional amount above par paid when the bond is called
Call Protection
Call protection is a period during which the bond cannot be called.
A 20-year bond issued in 2022 is first callable in 2032.
The investor has 10 years of call protection—guaranteed interest payments for a decade.
After 2032, the issuer can call the bond at any time.
Call Premium
A call premium is an additional amount paid above par when a bond is called. Typically, the call premium declines over time:
| Redemption Date | Redemption Price |
|---|---|
| 2032 | 105 ($1,050) |
| 2033 | 104 ($1,040) |
| 2034 | 103 ($1,030) |
| 2035 | 102 ($1,020) |
| 2036 | 101 ($1,010) |
| 2037+ | 100 ($1,000) |
- The issuer calls the bond
- The issuer pays the final interest payment
- The issuer returns principal plus any call premium
- The issuer can now sell new bonds at lower rates
(A low call premium also makes a call more likely. If the issuer only has to pay 101 to retire a bond paying 8%, that's a bargain compared to years of above-market interest payments.)
Yield to Call (YTC)
Yield to call (YTC) measures how the call feature affects an investor's return if the issuer decides to call.
Test Tip: When recommending callable bonds, the lesser of YTM or YTC must be disclosed so clients understand the lowest potential yield. This is called yield to worst (YTW).
YTC for Discount Bonds
When a bond trades at a discount, YTC is typically higher than YTM because the investor receives the gain between purchase price and par sooner.
Nominal Yield → Current Yield → YTM → YTC
(lowest to highest)
YTC is highest because the discount is recovered sooner.
YTC for Premium Bonds
When a bond trades at a premium, YTC is typically lower than YTM—bad news for investors. They lose the attractive higher-coupon payments sooner and lose the premium paid.
YTC → YTM → Current Yield → Nominal Yield
(lowest to highest)
YTC is lowest because the premium is lost sooner.
Test Tip: You won't calculate YTC, but you must understand:
- YTC > YTM for discount bonds
- YTC < YTM for premium bonds
- YTW for discount bond = YTM
- YTW for premium bond = YTC
Bond Put Features
A put feature gives the investor the right to sell the bond back to the issuer at a specified price (typically par). Also called a tender option.
| Feature | Who Has the Right? | Who Benefits? |
|---|---|---|
| Call | Issuer | Issuer (refinance at lower rates) |
| Put | Investor | Investor (exit at par if rates rise) |
When Do Investors Exercise Put Options?
When interest rates rise, bond prices fall. If the price drops below par, the bondholder can tender the bond and receive full par value, then reinvest at higher rates.
- Once issued, coupon rate and par value don't change
- Bond prices fluctuate based on interest rate changes
- Interest rates and bond prices have an inverse relationship (but this doesn't hold for junk bonds)
- When rates fall, callable bonds are likely to be called
- When rates rise, puttable bonds are likely to be redeemed
- Risk and coupon rates move in the same direction—greater risk means higher coupon
| Concept | Key Details |
|---|---|
| Bond call features | Allow issuer to retire bond prior to maturity |
| Yield to call | Measures actual yield if bond is called |
| Bond put features | Allow owner to redeem bond prior to maturity |
| When calls happen | Rates fall → callable bonds likely called |
| When puts happen | Rates rise → puttable bonds likely redeemed |
Section 2: Risks Associated with Bonds
In 2008, Lehman Brothers bondholders learned a brutal lesson: even investment-grade debt can become worthless overnight. The firm's bonds, rated A just months before, recovered only pennies on the dollar in bankruptcy.
Bond Ratings—A Measure of Default Risk
Credit risk (also default risk) is the risk that the issuer cannot make interest and principal payments. The two main rating agencies are Moody's and Standard & Poor's (S&P).
Treasury bonds are backed by the U.S. Treasury and carry a AAA rating with no credit risk.
Investment Grade vs. Speculative Grade
| Grade | S&P | Moody's |
|---|---|---|
| Investment Grade | AAA | Aaa |
| AA | Aa | |
| A | A | |
| BBB | Baa | |
| Speculative Grade | BB | Ba |
| B | B | |
| CCC | Caa | |
| CC, C, D | Ca, C |
Test Tip: S&P uses + or - modifiers (AA+, AA-). Moody's uses 1, 2, 3 (Aa1, Aa2, Aa3). Investment grade = BBB-/Baa3 or better.
Most institutions restrict investments to investment-grade bonds. Bonds below investment grade are called junk bonds or high-yield bonds.
Interest Rate Risk and Price Volatility
Interest rate risk is the risk that rising rates will cause bond prices to fall. Bonds with long maturities or low coupons are most susceptible.
Variable-Rate Bonds
Variable-rate bonds have coupons that adjust to match market rates. Because the yield adjusts, the price stays close to par.
When market rates rise, the variable-rate bond's coupon adjusts up, keeping the bond trading near par. Result: Variable-rate bonds do not have significant interest rate risk.
Price Volatility
| Factor | More Volatile | Less Volatile |
|---|---|---|
| Time to maturity | Longer maturity | Shorter maturity |
| Coupon rate | Lower coupon | Higher coupon |
Duration
Duration expresses a bond's overall sensitivity to interest rate swings.
- High duration = long maturity + low coupon = very volatile
- Low duration = short maturity + high coupon = very stable
- Large discount bond (lowest coupon)
- Small discount bond
- Par bond
- Small premium bond
- Large premium bond (highest coupon)
Most volatile of all: Long-term zero-coupon bonds—they have no interest payments, so their entire value depends on principal repayment at maturity.
Test Tip: Adjustable-rate bonds are suitable for investors looking for protection from interest rate risk.
Other Bond Risks
Systematic risk affects all investments (cannot be diversified away). Nonsystematic risk is unique to specific securities (can be diversified away).
| Risk | Affected Most By | Protection Strategy |
|---|---|---|
| Market risk | Stocks, high-yield bonds | Buy puts, short stock, ETFs |
| Purchasing power | Fixed-income securities | Stocks, REITs, TIPS |
| Interest rate | High-duration bonds | Stocks, convertible bonds |
| Credit/default | High-yield bonds | Safer bonds, U.S. Treasuries |
| Business | Stocks and bonds | Diversification |
| Liquidity | Private placements, DPPs, munis | Money market, large-caps, Treasuries |
| Currency | Foreign investments | Currency futures/options |
| Call | Callable bonds | Non-callable bonds |
| Reinvestment | Callable bonds, interest-paying bonds | Zero-coupon bonds (STRIPS) |
The risk that inflation reduces what your returns can buy. The only bonds offering protection are Treasury Inflation-Protected Securities (TIPS).
The risk that you can't reinvest returns at comparable rates. Call risk and prepayment risk both increase reinvestment risk—calls and prepayments are more likely when rates fall.
| Concept | Key Details |
|---|---|
| Bond ratings | S&P/Moody's; BBB/Baa or better = investment grade |
| Interest rate risk | Based on maturity and coupon rate |
| Duration | Long maturity + low coupon = high volatility |
| Systematic | Cannot be diversified away |
| Nonsystematic | Can be diversified away |
Chapter 3 Key Terms Glossary
| Term | Definition |
|---|---|
| Callable bond | Bond that issuer can redeem before maturity |
| Call protection | Period during which bond cannot be called |
| Call premium | Amount above par paid when bond is called |
| Call risk | Risk that bond will be called, ending interest early |
| Yield to call (YTC) | Yield calculation assuming bond is called |
| Yield to worst (YTW) | Lower of YTM or YTC; must be disclosed |
| Put feature | Gives investor right to sell bond back at specified price |
| Credit/default risk | Risk issuer cannot make payments |
| Investment grade | BBB/Baa or better rating |
| Speculative/junk | Below BBB/Baa (high-yield) |
| Interest rate risk | Risk that rising rates cause price decline |
| Variable-rate bond | Coupon adjusts to market rates |
| Duration | Measure of bond's sensitivity to rate changes |
| Systematic risk | Affects all investments; cannot diversify away |
| Nonsystematic risk | Unique to specific securities; can diversify |
| Purchasing power risk | Inflation reduces real returns |
| Reinvestment risk | Cannot reinvest at same rates |
| Liquidity risk | Cannot sell quickly at fair price |
| Currency risk | Exchange rate fluctuations |
Chapter 3 builds on Chapter 2's fundamentals by adding call/put features and the full spectrum of bond risks. Master these before moving to Chapter 4: Corporate, U.S. Government, and Agency Debt.