SIE Ready⚠️ Investment Risks · Lesson 3 of 5 · 5 min
Will They Pay, Can I Sell, Will They Call?
☎️ Your 7% bond is the best thing in your account, until the issuer calls it away the moment rates drop.
💡 Key idea
Credit risk = will they pay; liquidity risk = can I sell; call and prepayment risk = falling rates take your high-yielding security away early.
🧠 Why it matters
CREDIT (DEFAULT) RISK: the issuer may miss interest or principal. Ratings agencies grade it; investment grade is BBB/Baa and above, below that is high-yield ("junk"), which pays more to compensate. A downgrade usually lowers a bond's price. LIQUIDITY (MARKETABILITY) RISK: you may not find a buyer quickly at a fair price; it is higher for thinly traded, complex or early-withdrawal-penalty products. CALL RISK: when rates fall, an issuer may redeem callable bonds or preferred early, so the holder loses the high payment and must reinvest at lower rates. PREPAYMENT RISK is the mortgage-backed version: falling rates lead homeowners to refinance, returning principal early. When rates rise, prepayments slow and the holder waits longer for principal (extension risk).
📈 In the real world
🏘️ Lena owns a callable corporate bond paying 7%. Rates fall to 4%, and the issuer calls the bond at its call price. Lena gets her money back, but the best new bond of similar quality pays about 4%. Her neighbor's mortgage-backed security is returning principal faster for the same reason: homeowners are refinancing.
📌 Takeaways
- Credit risk is graded by ratings; below BBB/Baa is high-yield
- Liquidity risk: no quick buyer at a fair price
- Falling rates trigger call and prepayment risk; rising rates bring extension risk
📖 Terms in this lesson
Credit risk: The risk that an issuer fails to pay interest or principal on time.
Liquidity risk: The risk of being unable to sell quickly at a fair price.
Call risk: The risk that an issuer redeems a bond early, usually after rates fall, leaving the investor to reinvest at lower yields.
✅ Test yourself
Call risk is greatest for a callable bond when:
- Interest rates have risen sharply
- Interest rates have fallen sharply
- The issuer's rating was downgraded
- Inflation is running above forecast
Answer: B · Interest rates have fallen sharply
Issuers call bonds when they can refinance more cheaply, which happens after rates fall. Rising rates make a call unlikely; a downgrade raises the issuer's borrowing cost, which also makes a call less attractive.
Which rating is the lowest that is still considered investment grade?
- AA (or Aa)
- CCC (or Caa)
- BB (or Ba)
- BBB (or Baa)
Answer: D · BBB (or Baa)
Investment grade runs from AAA/Aaa down to BBB/Baa. BB/Ba and CCC/Caa are high-yield (below investment grade). AA/Aa is investment grade but not the lowest such rating.
An investor needs to be able to sell quickly at a fair price. Which risk is this investor most concerned about?
- Call risk
- Liquidity risk
- Reinvestment risk
- Purchasing power risk
Answer: B · Liquidity risk
Liquidity (marketability) risk is the risk of not finding a buyer quickly at a fair price. The other risks concern reinvesting cash flows, inflation and early redemption by the issuer.
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