Risk of Bond
Investment
Risks Associated
with Investing in Bonds.
interest rate risk
call and prepayment risk
yield curve risk
reinvestment risk
credit risk
liquidity risk
exchange-rate risk
volatility risk
inflation or purchasing power risk
event risk
sovereign risk
Interest Rate Risk
Higher YTM (yield required by market)
Lower Price
coupon rate = yield required by market price = par value
coupon rate < yield required by market price < par value (discount)
coupon rate > yield required by market price > par value (premium
Bond Features that Affect
Interest Rate Risk
The Impact of Maturity : the longer the
bonds maturity, the greater the bonds
price sensitivity to changes in interest
rates.
The Impact of Coupon Rate: the lower the
coupon rate, the greater the bonds price
sensitivity to changes in interest rates.
Bond Features that Affect
Interest Rate Risk
The Impact of Embedded Options
price of callable bond = price of option-free
bond price of embedded call option
The Impact of the Yield Level
Price sensitivity is higher when the level of
interest rates is low.
Interest Rate Risk for Floating-
Rate Securities
The longer the time to the next coupon reset
date, the greater the potential price fluctuation.
The required margin that investors demand in
the market changes.
Once the cap is reached, the securitys price will
react much the same way to changes in market
interest rates as that of a fixed-rate coupon
security. This risk for a floating-rate security is
called cap risk.
Measuring Interest Rate Risk
1. Approximate Percentage Price Change
the approximate percentage price
change for a 100 basis point change in
yield
=
Measuring Interest Rate Risk
2. Approximating the Dollar Price Change
Dollar duration: The approximate dollar
price change for a 100 basis point change
in yield
Yield Curve Risk
Interest rates or yields in the market
change, the price of a bond change.
yield curve risk: bond portfolios have
different exposures to how the yield curve
shifts.
Yield Curve Risk
Parallel shift
Yield Curve Risk
Non parallel shift
Call and Prepayment Risk
Call provisions disadvantage
The cash flow pattern of a callable bond is not known
with certainty because it is not known when the bond
will be called.
Issuer is likely to call the bonds when interest rates
have declined below the bonds coupon rate, the
investor is exposed to reinvestment risk. (Reinvest
the proceeds when the bond is called at interest rates
lower than the bonds coupon rate)
Call and Prepayment Risk
Call provisions disadvantage
The price appreciation potential of the bond will be
reduced relative to an otherwise comparable option-
free bond. (This is called price compression.)
Call and Prepayment Risk
Prepayment risk: The same
disadvantages apply to mortgage-backed
and asset-backed securities where the
borrower can prepay principal prior to
scheduled principal payment dates.
Reinvestment Risk
Reinvestment risk is the risk that the
proceeds received from the payment of
interest and principal (i.e., scheduled
payments, called proceeds, and principal
prepayments) that are available for
reinvestment must be reinvested at a
lower interest rate than the security that
generated the proceeds
Credit Risk
1. default risk
2. credit spread risk
3. downgrade risk
Credit Risk: Default Risk
risk that the issuer will fail to satisfy the
terms of the obligation with respect to the
timely payment of interest and principal.
Credit Risk: Credit Spread Risk
The risk that an issuers debt obligation
will decline due to an increase in the credit
spread.
Credit Risk: Downgrade Risk
An unanticipated downgrading of an issue
or issuer increases the credit spread and
results in a decline in the price of the issue
or the issuers bonds.
Liquidity risk
is the risk that the investor will have to
sell a bond below its indicated value,
where the indication is revealed by a
recent transaction.
Bid-ask Spread: Measure of
Liquidity Risk
the bid-ask spread can be computed by
looking at the best bid price (high price at
which a broker/dealer is willing to buy a
security) and the lowest ask price (lowest
offer price at which a broker/dealer is
willing to sell the same security)
Exchange Rate or Currency
Risk
The risk of receiving less of the domestic
currency when investing in a bond issue
that makes payments in a currency other
than the managers domestic currency.
Inflation or Purchasing Power
Risk
arises from the decline in the value of a
securitys cash flows due to inflation,
which is measured in terms of purchasing
power.
Volatility Risk
Price of callable bond
= Price of option-free bond
Price of embedded call option
If expected yield volatility increases,
holding all other factors constant, the price
of the embedded call option will increases
Volatility Risk
Price of putable bond
= Price of option-free bond
+ Price of embedded put option
A decrease in expected yield volatility
reduces the price of the embedded put
option and therefore will decrease the
price of a putable bond.
Volatility Risk
Type of embedded Volatility risk due to
option
Callable bonds an increase in expected
yield volatility
Putable bonds a decrease in expected
yield volatility
Event Risk
Occasionally the ability of an issuer to
make interest and principal payments
changes dramatically and unexpectedly
because of
natural disaster,
a takeover or corporate restructuring,
a regulatory change
Sovereign Risk
the risk that, as a result of actions of the
foreign government, there may be either a
default or an adverse price change even in the
absence of a default.
Sovereign risk consists of two parts.
the unwillingness of a foreign government to pay. A
foreign government may simply repudiate its debt.
the inability to pay due to unfavorable economic
conditions in the country.
