risk of bond investment

8/9/2019 Risk of Bond Investment

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Risk of Bond

Investment


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Risks Associatedwith 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


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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


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Bond Features that AffectInterest Rate Risk

The Impact of Maturity : the longer thebonds maturity, the greater the bonds

rice sensitivit to chan es in interest

rates.

The Impact of Coupon Rate: the lower the

coupon rate, the greater the bonds pricesensitivity to changes in interest rates.


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Bond Features that AffectInterest Rate Risk

The Impact of Embedded Options price of callable bond = price of option-free


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The Impact of the Yield Level

Price sensitivity is higher when the level ofinterest rates is low.


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Interest Rate Risk for Floating-Rate Securities

The longer the time to the next coupon resetdate, 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 couponsecurity. This risk for a floating-rate security iscalled cap risk.


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Measuring Interest Rate Risk

1. Approximate Percentage Price Changethe approximate percentage price

yield

=


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Measuring Interest Rate Risk

2. Approximating the Dollar Price Change Dollar duration: The approximate dollar

in yield


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Yield Curve Risk

Interest rates or yields in the marketchange, the price of a bond change.

different exposures to how the yield curveshifts.


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Yield Curve Risk Parallel shift


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Yield Curve Risk Non parallel shift


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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

w e ca e . Issuer is likely to call the bonds when interest rates

have declined below the bonds coupon rate, theinvestor is exposed to reinvestment risk. (Reinvest

the proceeds when the bond is called at interest rateslower than the bonds coupon rate)


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Call provisions disadvantage The price appreciation potential of the bond will be

reduced relative to an otherwise comparable option-ree on . s s ca e pr ce compress on.


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Prepayment risk: The samedisadvantages apply to mortgage-backedand asset-backed securities where the

borrower can prepay principal prior toscheduled principal payment dates.


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Reinvestment Risk

Reinvestment risk is the risk that theproceeds received from the payment ofinterest and rinci al i.e. scheduled

payments, called proceeds, and principalprepayments) that are available forreinvestment must be reinvested at a

lower interest rate than the security thatgenerated the proceeds


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Credit Risk

1. default risk 2. credit spread risk

.


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Credit Risk: Default Risk

risk that the issuer will fail to satisfy theterms of the obligation with respect to thetimely payment of interest and principal.


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Credit Risk: Credit Spread Risk

The risk that an issuers debt obligationwill decline due to an increase in the creditspread.


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Credit Risk: Downgrade Risk

An unanticipated downgrading of an issueor issuer increases the credit spread andresults in a decline in the rice of the issue

or the issuers bonds.


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Liquidity risk

is the risk that the investor will have tosell a bond below its indicated value,where the indication is revealed b a

recent transaction.


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Bid-ask Spread: Measure ofLiquidity Risk

the bid-ask spread can be computed bylooking at the best bid price (high price atwhich a broker dealer is willin to bu a

security) and the lowest ask price (lowestoffer price at which a broker/dealer iswilling to sell the same security)


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Exchange Rate or CurrencyRisk

The risk of receiving less of the domesticcurrency when investing in a bond issuethat makes a ments in a currenc other

than the managers domestic currency.


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Inflation or Purchasing PowerRisk

arises from the decline in the value of asecuritys cash flows due to inflation,which is measured in terms of urchasin

power.


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Volatility Risk

Price of callable bond= Price of option-free bond

If expected yield volatility increases,holding all other factors constant, the price

of the embedded call option will increases


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Volatility Risk

Price of putable bond= Price of option-free bond

A decrease in expected yield volatilityreduces the price of the embedded put

option and therefore will decrease theprice of a putable bond.


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Volatility Risk

Type of embeddedoption Volatility risk due to

Callable bonds an increase in expected

yield volatilityPutable bonds a decrease in expected

yield volatility


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Event Risk

Occasionally the ability of an issuer tomake interest and principal paymentschan es dramaticall and unex ectedl

because ofnatural disaster,

a takeover or corporate restructuring,

a regulatory change


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Sovereign Risk

the risk that, as a result of actions of theforeign government, there may be either adefault or an adverse price change even in the

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 economicconditions in the country.

risk of bond investment

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