This article was written by Scott Eldridge, Director of Fixed Income Product Strategy for Invesco PowerShares Capital Management LLC.

Extension risk is often unanticipated, but can adversely affect fixed income investors during periods of rising interest rates

When interest rates fall, it’s not uncommon for investors to see their callable bonds redeemed before maturity. For issuers, calling bonds is a chance to refinance debt at lower rates. For investors, a bond call is the source of considerable angst, but one for which they are typically compensated through higher yields – at least until the bond call itself.

But call features can have unpleasant consequences when rates rise as well. Lurking just below the surface is something known as extension risk. Extension risk is a little-appreciated aspect of how callable securities can behave in a rising rate environment. Too often, extension risk will sneak up on unsuspecting investors, leaving them wondering what happened. Extension risk can be prevalent in securities with imbedded call features and fixed coupons, which is often the case in mortgage-backed, municipal, and fixed preferred securities. In my view, too many investors think of their preferred “stocks” as equity-like, ignoring the very bond-like risks that these hybrid securities typically carry in a rising rate environment.

Declining interest rates increase call risk …

Extension risk stems from the fact that a callable security’s sensitivity to interest rate movements (typically measured by duration) is not static. It changes according to the likelihood of that security being called away. Generally, a callable security is less sensitive to interest rate movements when rates are low , because that bond is more likely to be called. Conversely, a callable security is less likely to be called as interest rates rise, and its price becomes more dependent on interest rate levels.

An issuer views a callable security much like you would your mortgage. If interest rates are low, you would take advantage of the opportunity to refinance. That’s what the call feature allows the bond issuer to do – call away the higher coupon bond outstanding and replace it with a cheaper form of capital.

Because the market expects the issuer to take advantage of the call feature when interest rates are low, the bonds are treated as if they will be around only until their call date. Thus, a callable bond’s sensitivity to interest rate changes will be little different from that of a non-callable bond – known as a bullet bond – that matures on or near that call date.

… But rising interest rates increase extension risk

But what happens when rates start to rise? Initially, the callable bond behaves very much like a non-callable bullet bond. With market rates still below the callable bond’s coupon, the likelihood of the bond being called is high, and interest rate sensitivity (duration) is low.

As market rates approach the callable bond’s coupon, however, the likelihood of the issuer calling the bond decreases. At the same time, the callable bond’s expected life “extends,” and markets start to treat the bond like a longer maturing instrument with greater interest rate risk. The risk of the bond’s effective maturity lengthening is known as extension risk. This phenomenon is illustrated in the chart below, with a few caveats below it.

Extension risk in action

Unsuspecting investors may be tracking a security with relatively low interest rate risk, only to wake up one day facing a much more volatile instrument with high rate sensitivity.

Strategies for dealing with extension risk