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3. Include your references if you have used some for analysis and evaluation.
It is harder to negotiate a deal when a debtor does get into trouble, and it is
increasingly difficult to know just where the risk resides.
In the 1980's it was possible to get 20 banks in a room and be confident that all the
important players were there, and were able to cut a deal if they wished to do so.
Now with capital markets rather than banks making the loans, it is hard to know who
has the risk, and virtually impossible to get them all together. If you knew who owned
the bonds, which is not easy to find out even for the issuer, the existence of credit
derivatives means you cannot be sure who really stands to suffer from a default. There
is no way to be sure, until it is too late, whether derivatives are allowing risks to be
spread around or whether they are concentrating risks in a dangerous way.
Argentina didn't default because it couldn't pay its bondholders. It
defaulted because a New York judge wouldn't let it pay its bondholders
—not unless it also paid the hedge funds that were holding out for a
better deal on its old defaulted debt.
This is a lose-lose-lose situation. The holdouts aren't happy, because
they still aren't getting paid. The exchange bondholders aren't happy,
because now they aren't getting paid either. And Argentina isn't
happy, because it was forced into a default it didn't want—though, at
this point, it can't really suffer any reputational damage.
Since then, Argentina has not shown an excess of eagerness to reach a deal with its
creditors.
Interest rates and bonds have an inverse relationship: When interest rates
rise, bond prices fall, and vice versa. Newly issued bonds will have higher
coupons after rates rise, making bonds with low coupons issued in the lower-
rate environment worth less.
Interest rate risk directly affects the values of fixed income securities. Since
interest rates and bond prices are inversely related, the risk associated with a
rise in interest rates causes bond prices to fall and vice versa.
Interest rate risk affects the prices of bonds, and all bondholders face this type of
risk. As mentioned above, it's important to remember that as interest rates rise,
bond prices fall.
Long term bonds are most sensitive to interest rate changes. The reason lies in
the fixed-income nature of bonds: when an investor purchases a corporate bond,
for instance, they are actually purchasing a portion of a company's debt. This
debt is issued with specific details regarding periodic coupon payments,
the principal amount of the debt and the time period until the bond's maturity.
Here, we detail why it is that bonds with longer maturities expose investors to
greater interest rate risk than short-term bonds.
When interest rates rise, bond prices fall (and vice-versa), with long-
maturity bonds most sensitive to rate changes.
This is because longer-term bonds have a greater duration that near-term
bonds that are closer to maturity and have less coupon payments
remaining.
Long-term bonds are also exposed to a greater probability that interest
rates will change over its remaining duration.
Interest rate risk arises when the absolute level of interest rates fluctuate. Interest
rate risk directly affects the values of fixed income securities. Since interest rates
and bond prices are inversely related, the risk associated with a rise in interest
rates causes bond prices to fall and vice versa.
Interest rate risk affects the prices of bonds, and all bondholders face this type of
risk. As mentioned above, it's important to remember that as interest rates rise,
bond prices fall. When interest rates rise and new bonds with higher yields than
older securities are issued in the market, investors tend to purchase the new
bond issues to take advantage of the higher yields.
For this reason, the older bonds based on the previous level of interest rate have
less value, and so investors and traders sell their old bonds and the prices of
those decrease.
Conversely, when interest rates fall, bond prices tend to rise. When interest rates
fall and new bonds with lower yields than older fixed-income securities are issued
in the market, investors are less likely to purchase new issues. Hence, the older
bonds that have higher yields tend to increase in price.
Investors can reduce, or hedge, interest rate risk with forward contracts, interest
rate swaps and futures. Investors may desire reduced interest rate risk to reduce
uncertainty of changing rates affecting the value of their investments. This risk is
greater for investors in bonds, real estate investment trusts (REITs) and other
stocks in which dividends make up a healthy portion of cash flows.
Primarily, investors are concerned about interest rate risk when they are worried
about inflationary pressures, excessive government spending or an unstable
currency. All of these factors have the ability to lead to higher inflation, which
results in higher interest rates. Higher interest rates are particularly deleterious
for fixed income, as the cash flows erode in value.
Investors holding long term bonds are subject to a greater degree of interest rate
risk than those holding shorter term bonds. This means that if interest rates
change by, say 1%, long term bonds will see a greater change to their price -
rising when rates fall, and falling when rates rise. Explained by their greater
duration measure, interest rate risk is often not a big deal for those holding bonds
until maturity. For those who are more active traders, however, hedging
strategies may be employed to reduce the effect of changing interest rates on
bond portfolios.