What is the effect of a bond being called before maturity during a falling interest rate environment?

When a bond is called before maturity during a falling interest rate environment, it creates a situation known as reinvestment risk for investors. This occurs because the bond issuer calls the bond to reissue new debt at a lower interest rate, which generally happens when rates decline.

For investors, being paid back their principal before maturity means they must find a new investment opportunity for that capital. However, in a declining interest rate scenario, the options available for reinvestment are likely to yield lower returns than the original bond, which could have offered a higher interest rate. This creates a challenge as investors may not be able to achieve comparable returns on their reinvested funds. Consequently, reinvestment risk significantly impacts the overall returns on their investments.

In contrast, while increased cash flow might seem favorable, it can be misleading as it actually signifies the early return of principal, rather than a sustained yield. Lower taxes on investment returns does not directly relate to the consequences of a bond being called, nor does higher portfolio volatility specifically stem from the call feature in this context. Therefore, the most accurate consequence of a bond being called in this scenario is indeed reinvestment risk for investors.