Chartered Financial Analyst (CFA) Practice Exam Level 2

Callable bonds generally have lower prices than non-callable bonds due to which risk?

1. Default Risk

2. Reinvestment Risk

3. Interest Rate Risk

4. Credit Risk

The correct answer is: Reinvestment Risk

Callable bonds typically have lower prices than non-callable bonds primarily because of reinvestment risk. When interest rates decline, the issuer of a callable bond has the option to redeem the bond before its maturity date. This can force the bondholder to reinvest the proceeds at lower prevailing interest rates, which might yield less favorable returns compared to the original investment. This potential for early redemption creates uncertainty for investors about future cash flows. Unlike non-callable bonds, which guarantee a stream of payments until maturity, callable bonds expose investors to the possibility of having to reinvest at inopportune times, particularly when rates are lower. Consequently, to compensate for this additional risk, callable bonds usually offer higher yields, but their market prices are generally lower compared to comparable non-callable bonds, reflecting the risk of reinvestment and the associated impact on the total return. Considering the other risks mentioned, although credit risk or default risk pertains to the likelihood of the issuer failing to meet its payment obligations, these risks are typically factored into the bond's credit rating rather than directly influencing the price discrepancy between callable and non-callable bonds. Interest rate risk affects the price of both types of bonds but does not specifically explain why callable bonds trade at lower prices relative to