Long Term Bonds and the Callable Option

When considering long-term bonds and the callable option, the most significant factor to understand is reinvestment risk. A long-term bond typically has a maturity up to 30 years. If you buy a standard bond and hold it until maturity, you will receive interest payments for the entire term. Some bonds, however, are callable. The call option gives the issuer the right to retire the debt by returning the principal to the bondholder at a predetermined price. If you own a long-term bond that it is called, you will receive a final principal payment, but interest payments will stop.

Risk

If this occurs, you face reinvestment risk. This is the risk that you will have to reinvest the capital at a lower rate because of a move in interest rates. Bonds are rarely called when rates rise. This is because the company is content to make payments at the lower rate. If rates fall, however, the company can retire the debt and issue new debt at lower rates. When this happens, you will have to buy new bonds at the now lower rates. There are other risks associated with both long-term and callable bonds, but reinvestment risk is the most significant. You should understand this risk before buying this type of instrument.

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