Call Risk Versus Extension Risk

A recent research piece from Citigroup discussed a core concern in the municipal bond market as the expectation for higher interest rates becomes nearer.  The majority of bonds issued in the municipal market that have more than 10 years to maturity at the time of issuance are issued with embedded call options.  If rates are lower than they were when the bond was issued, at the time when the option becomes executable, then the issuer will call the bonds and re-issue at lower rates.  This is call risk, as the investor is then sitting in cash and forced to re-invest in the existing lower rate environment.  On the other hand, if prevailing market rates are higher, the issuer will choose not to call the bonds, and an investor expecting bonds to be called away will find themselves owning a longer duration asset than anticipated.  This is extension risk, and is often accompanied by a drop in price for the bond as the market revalues the bond to the final maturity rather than to the call.  We pay close attention to this risk as we believe that select callable structures with limited extension risk can enhance yield and compensate investors for the incremental risk.  However, too often we see portfolios and mutual funds where the true interest rate risk is materially understated due to the lack of accounting for this extension risk and the associated re-pricing these bonds will be subject to.  Citi estimates that there is still a significant cushion, approximately 120-150bps in higher rates, against extension risk for bonds that have 18 months or less until the call option becomes executable.  However, given the expectation for higher rates outside that timeframe, for bonds with longer dated calls there is less certainty and this will magnify the volatility and negative price action for structures with long periods of time between the call date and the final maturity.