Banking Terms - Set 16 (Call risk, Default risk & Reinvestment risk on bond, Accrual bond, Irredeemable bonds)

Reinvestment Risk on bonds

When the yield of a bond is calculated, it is assumed that the coupons received before maturity is being reinvested. That additional income [received from such reinvestment] is sometimes referred to as interest-on-interest which depends on the prevailing interest-rate levels at the time of reinvestment. Volatility in this reinvestment rate because of changes in market interest rates is called reinvestment risk.

Accrual Bond

A bond on which interest amount accrues, but is not paid to the investor during the time of accrual. The amount of accrued interest is added to the remaining principal of the bond and is paid at the time of maturity. We can simply say it to be like Cumulative Deposits kind of.

Irredeemable bonds

Bonds with a fixed maturity but not subject to prior redemption; bonds that cannot be called for redemption by the issuer (payer or obligor) before maturity. They should not be confused with perpetual bonds or intermediate bonds. UK Irredeemable (undated) bonds have no final maturity date. They are callable by the government at any time within 3 months. As their coupons range between 2.5% and 4% they are unlikely to be called. War loan, issued by the UK government during the First World War, is the best known of this kind.

Default Risk on Bonds

Issuers could potentially run into cash flow problems, simultaneously attaches default risk to their bonds if there is uncertainty whether they can afford to pay coupons and principals. Bonds with default risk trade in the market at a price that is lower than comparable U.S. Treasury securities, which are considered free of default risk. Default risk is gauged by quality ratings assigned by recognized rating companies such as Moody’s Investor Service, Standard & Poor’s corporation, Morningstar and Fitch IBCA. Also referred to as credit risk.

Call risk on bonds

Usually bonds include a call feature that allows the issuer to redeem (call) all or part of the bonds issued before the maturity date. The issuer usually retains this right in order to have flexibility to re-finance the bond in the future, if the market interest rate drops below the coupon rate.