RISK IN BOND MARKET

INTEREST RATE RISK

The most well-known risk in the bond market is interest rate risk - the risk that bond
prices will fall as interest rates rise. By buying a bond, the bondholder has committed
to receiving a fixed rate of return for a fixed period. Should the market interest rate
rise from the date of the bond's purchase, the bond's price will fall accordingly. The
bond will then be trading at a discount to reflect the lower return that an investor will
make on the bond.

Simply put: as interest rates rise, bond prices fall, and vice versa.

Why does this happen? Theoretically, as interest rates increase, the opportunity cost
– or the cost of missing investments of potentially greater value – of holding money
increases, as investors are losing out on the rate of interest earned on bonds and
other investments.

Still, because bonds have a fixed coupon rate, when interest rates increase above
this fixed level, investors are able to realize greater yields elsewhere by switching to
investments that reflect the higher interest rate. Only by having lower selling prices
can past securities with lower rates become competitive with securities issued after
market interest rates have turned higher.

If an investor buys a 20-year bond that costs Rs 100 with a 6% coupon, interest

rates may rise to 6.5%,the price of this bond may decline to Rs 94.4479.Thus for a
50bps point increase, price of this bond would decline by 5.55%.If instead, yield
declines to 5.5%,bonds price will rise by 6.02% to Rs. 106.0195.

Since the price of bond fluctuates with market interest rates, the risk that an investor
faces is that the price of a bond held in a portfolio will decline if market interest rate
rise. This risk is referred as interest rate risk and is the major risk faced by investors
in the bond market.

Reason for inverse relationship between interest rate and price

When interest rates increase in an economy, in that case, the investor may have
difficulty selling the bond when other bond offerings enter the market, with more
attractive rates. Older bonds look less attractive as newly issued bonds carry higher
coupon rates as well. Furthermore, lower demand may trigger lower prices on the
secondary market, and the investor may consequently earn less for the bond on the
market than he paid for it. 
The reverse is also true. A 20 year bond yielding a 6% return holds more value if
interest rates decrease below this level, since the bondholder receives a fixed rate of
return relative to the market, which is offering a lower rate of return as a result of the
decrease in rates.

To Summarize:

1. A bond will trade at a price equal to par when the coupon rate is equal to the
yield required by market.
2. A bond will trade at price above par (at premium) or below par (at discount) if
coupon rate is different from yield required my market.

Coupon rate>Required yield then, bond trades at premium

Coupon rate < required yield then, bond trades at discount

3. The price of bond changes in opposite direction to the change in interest

rates.

Market interest rates are a function of several factors such as the demand for, and
supply of, money in the economy, the inflation rate, the stage that the business cycle
is in as well as the government's monetary and fiscal policies

Bond features that affect interest rate risk

1. Impact of maturity

All other factors constant, the longer the bonds maturity, the greater the bonds price
sensitivity to changes in interest rates.

The value of existing fixed-income securities with different maturities declines by

various degrees when market interest rates rise. This phenomenon is referred to as
“price sensitivity,” meaning that prices on securities of certain maturity lengths are
more sensitive to increases in market interest rates, resulting in sharper declines in
their security values. For example, suppose there are two fixed-income securities,
where one matures in one year and the other matures in 10 years. When market
interest rates rise, holders of the one-year security could reinvest in a higher-rate
security after having a lower return for only one year. Contrarily, holders of the 10-
year security would be stuck with a lower rate for nine more years, justifying a
comparably lower security value than shorter-term securities to attract willing buyers.
The longer a security's maturity, the more its price declines to a given increase in
interest rates. Note that the sensitivity occurs at a decreasing rate, meaning that
while a 10-year bond is significantly more sensitive than a 1-year bond, a 20-year
bond is only slightly less sensitive than a 30-year one.

2. Impact of coupon rate

All other factors constant, the lower the coupon rate, the greater is the bond’s price
sensitivity to changes in interest rates.

An implication is that zero coupon bonds have greater price sensitivity to interest rate
changes than same maturity bonds bearing a coupon rate and trading at same yield.

The key concept here is called Yield to Maturity (YTM). This is the yield that bond
has when held until its redemption date. It is calculated from the coupon and the
price the bond trades at today. (Which may not be face.) What happens is that as
interest rates rise and fall, the price that a bond will buy or sell for adjusts so that the
YTM matches the current YTM of new similar bonds.

For e.g. Suppose that we have two treasury bonds that have 5 years left on them.
(They were issued at different times with different maturities.) One pays 4%, one
pays 2%. Now suppose that the yield of newly issued 5 years treasuries is 5%. What
will happen? The price of the two bonds will adjust down until the effective yield
based on the price the bond trades for is 5%. The price of the 4% bond will have to
fall by about 4.5% of face, and the price of the 2% will fall by about 13% of face.

3. Yield level in market

For a given change in interest rates, price sensitivity is lower when the level of
interest rates in the market is high. The reason for that is when the interest rates
prevailing in market are high, the interest rate risk reduces because interest rate
cannot increase perpetually unless the circumstances are very exceptional. Chances
are more likely that prevailing high interest rates would come down.

Yield curve risk

Yield curve risk is the risk of changes in yield curve.

Yield curve is the relationship between different maturities (from short term to long
term) and their respective yields.

A portfolio of bond is a collection of bond issues typically with different maturities. So,
when interest rate changes, the price of each bond in the portfolio will change and
the portfolio value will change.
Portfolios have different exposures to how the yield curve shifts. This risk exposure
is called yield curve risk.

Changes in yield curve can be of two types:Parallel shift in yield curve and non
parallel shift in yield curve.

Reinvestment Risk

Reinvestment risk is the risk that future cash flows—either coupons (the periodic
interest payments on the bond) or the final return of principal—will need to be
reinvested in lower-yielding securities.
Each year the investor receives $120 (12%*$1,000), which can be reinvested back
into another bond. But imagine that over time the market rate falls to 10%. Suddenly,
that $120 received from the bond can only be reinvested at 10%, instead of the rate
of the original bond at 12%.

Reinvestment risk also occurs with callable bonds. “Callable” means that the issuer
can pay off the bond before maturity. One of the primary reasons bonds are called is
because interest rates have fallen since the bond's issuance and the corporation or
the government can now issue new bonds with lower rates, thus saving the
difference between the older higher rate and the new lower rate.

It makes sense for the issuer to do this and it's a part of the contract the investor
agrees to when buying a callable bond, but, unfortunately, this also means that once
again, the investor will have to put the cash back to work at the lower prevailing rate.

With an understanding of reinvestment risk, we can now appreciate why zero coupon
bonds may be attractive to certain investors. Because there are no coupon payments
to re-invest, there is no reinvestment risk. That is ,zero coupon bond eliminate
reinvestment risk. On flip side, ZCB are exposed to greatest interest rate risk.

Thus, a better way of at least partially mitigating reinvestment risk is to create

a “bond ladder,” a portfolio holding bonds with widely varied maturity dates. Because
the market is essentially cyclical, high-interest rates fall too low and then rise again.
Chances are only some of your bonds will mature in a low-interest rate environment
and these can usually be offset by other bonds that mature when interest rates are
high. 

Credit Risk

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a
loan or meet contractual obligations. Traditionally, it refers to the risk that a lender
may not receive the owed principal and interest, which results in an interruption of
cash flows and increased costs for collection. Although it's impossible to know
exactly who will default on obligations, properly assessing and managing credit risk
can lessen the severity of loss. Interest payments from the borrower or issuer of a
debt obligation are a lender's or investor's reward for assuming credit risk.

An investor who lends funds by purchasing a bond issue is exposed to credit risk.
There are three types of credit risk:

1. Default risk – Default risk is defined as the risk that the issuer will fail to satisfy
the terms of the obligation with respect to the timely payment of interest and
principal.
Credit ratings services such as Moody's, Standard & Poor's and Fitch give
credit ratings to bond issues, which helps to give investors an idea of how
likely it is that a payment default will occur. For example, most federal
 governments have very high credit ratings (AAA); they can raise taxes or print
money to pay debts, making default unlikely. However,
small, emerging companies have some of the worst credit (BB and lower).
They are much more likely to default on their bond payments, in which case
bondholders will likely lose all or most of their investment.
For. Eg Suzlon energy defaults on bond payments woth Rs 1182 cr.
DHFL defaulted on CP payment of Rs 200 cr.Was on verge on defaulting Rs
1000 cr payment in June 2019.

2. Credit Spread Risk – Yield on a bond is made up of two components 1) yield

on a similar default free bond issue (2) a premium above the yield on a default
free bond issue necessary to compensate for the risk associated with the
bond. The risk premium is referred to as yield spread. In any country,
Treasury issues are the benchmark yield because they are believed to be
default free, they are highly liquid and not callable. Part of risk premium or
yield spread attributable to default risk is called the credit spread.
The price performance of a non treasury bond issue and return over some
time period will depend on how the credit spread changes. If the credit spread
increases, yield goes up and price goes down. Investors says that credit
spread has widened. The risk that an issuer’s debt obligation will decline due
to an increase in the credit spread is called credit spread risk.

3. Downgrade Risk - A downgrade is a negative change in the rating of a

security. This situation occurs when analysts feel that the future prospects for
the security have weakened from the original recommendation, usually due to
a material and fundamental change in the company's operations, future
outlook, or industry. A downgrade of stock would be moving the rating from a
buy to a hold, or a hold to a sell.
Debt has its rating system as well. When a bond is downgraded, it might
move from an "AAA" rating to a "BBB" rating. Bond market can be divided into
two sectors- Investment grade and non investment grade bonds. Bonds with
rating AAA,AA,A and BBB are considered investment grade bonds. Bonds
with Rating below BBB are considered non investment/High yield /junk bonds.

A credit rating is an indicator of the potential default risk associated with a

particular bond issue or issuer. It represents in a simplistic way the credit
rating agency’s assessment of an issuers’s ability to meet the payment of
principal and interest in accordance with the terms of the indenture.
Once a credit rating is assigned to a debt obligation, a rating agency monitors
the credit quality of the issuer and can reassign a different credit rating. An
improvement in the credit quality of the issuer or issue is rewarded with a
better credit rating, referred to as an upgrade, a deterioration in the credit
 rating of an issue or an issuer is penalized by the assignment of an inferior
credit rating, referred to as a downgrade. An unanticipated downgrading of an
issue or issuer increases the credit spread and results in decline in the price
of the issue or the issuer’s bonds. This risk is referred to as downgrade risk
and is closely related to credit spread risk.

Liquidity Risk

When an investor wants to sell a bond prior to the maturity date, he is concerned
with whether or not the bid price from broker/dealer is close to the indicated value of
an issue.

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. The primary measure
of liquidity is the size of the spread between the bid price and the ask price. Bid price
is the price at which a dealer is willing to buy a security. Ask Price is the price at
which dealer is willing to sell a security. The wider the bid ask spread, the greater the
liquidity risk. A liquid market can generally be defined by small bid ask spreads which
do not materially increase for large transactions. From market perspective, bid ask
spread can be computed by looking at the best bid price and the lowest ask price.
This liquidity measure is called bid ask spread.

Call Risk/Prepayment risk

The risk that a bond will be called by its issuer. Callable bonds have call provisions,
which allow the bond issuer to purchase the bond back from the bondholders and
retire the issue. This is usually done when interest rates have fallen substantially
since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds
and sell low-rate bonds in a bid to lower debt costs. So when interest rate are falling,
the issuer may find it advantageous to call back the old issue and make a fresh issue
at lower interest rates. If he does so, you are required to exit your investment and
reinvest at lower interest rates. This suddenly reduces your returns. If call price is
lower than market price ,it further reduces returns as it leads to loss of capital
appreciation.

Inflation Risk  

The risk that the rate of price increases in the economy deteriorates the returns
associated with the bond. This has the greatest effect on fixed bonds, which have a
set interest rate from inception. For example, if an investor purchases a 8% fixed
bond and then inflation rises to 10% a year, the bondholder will lose money on the
investment in real terms because the purchasing power of the proceeds has been
greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted
periodically to match inflation rates, limiting investors' exposure to inflation risk.

Sovereign Risk

Sovereign debt can be broken down into two broad categories. Bonds issued by
large, developed economies (such as Germany, Switzerland or Canada) usually
carry very high credit ratings, are considered extremely safe and offer relatively low
yields. The second broad category of sovereign debt encompasses bonds issued by
developing countries - often referred to as emerging market bonds. These bonds
often carry lower credit ratings than developed nation sovereigns, and may actually
be rated as junk. Because they are perceived as being riskier, emerging market
bonds often provide higher yields.
Sovereign is one of many risks that an investor faces when holding forex contracts.
These risks also include interest rate risk, price risk, and liquidity risk.

Sovereign risk comes in many forms, although anyone who faces sovereign risk is
exposed to a foreign country in some way. Foreign exchange traders and investors
face the risk that a foreign central bank will change its monetary policy so that it
affects currency trades. Recent example is Rupee Dollar swap facility by RBI to
infuse liquidity into system.

Sovereign risk is also made up of political risk that arises when a foreign nation
refuses to comply with a previous payment agreement, as is the case with sovereign
debt.