Fixed income analysis

Various Risks Associated with Investment in Bonds
Extracted from Fabozzi Chapter

• Major learning outcomes:
– Understand the various risks associated with investing in bonds:
• • • • • • • • • • Interest rate, Yield curve Reinvestment Call and prepayment Credit Liquidity Exchange-rate Inflation Volatility Event Sovereign

Yield Curve Risk
• Another key factor that affects the price sensitivity of a bond (or a portfolio of bonds) is the change in market interest rates relative to the bonds‘ maturity. • If there were only one interest rate or yield in an economy the task of estimating the impact of changing yield on a bond portfolio would be easy, but there are numerous rates – often based on differing maturity structures.

• The important relationship to understand is between yield and maturity and it is displaced graphically as the yield curve.
– Future chapters in the text continue the discussion of the yield curve and yield spreads. Duration

.e. one for each maturity. • Therefore to determine the impact of interest rate risk on a portfolio of bonds with differing maturities.Yield Curve Risk • The yield curve is actually a series of yields. 5-year rate). a rate duration is computed to measure the impact of a rate change in at particular maturity (i.

. falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond. – This is the risk resulting from the fact that interest earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. Because the issuer is likely to call the bonds when interest rates have declined below the bond‘s coupon rate. 2. the investor is exposed to reinvestment risk. For example. The cash flow pattern of a callable bond is not known with certainty because it is not known when the bond will be called. 3. The price appreciation potential of the bond will be reduced relative to a comparable option-free bond.Call and Reinvestment Risk • There are three disadvantages to call provisions from an investor‘s perspective: 1.

• . This is referred to as prepayment risk.Prepayment Risk for Mortgageand Asset-Backed Bonds • The same disadvantages apply to mortgage.and asset-backed bonds where the borrower can prepay principal prior to scheduled principal payment dates.

Default risk 2.Credit Risk There are three types of credit risk: 1. Downgrade risk It is important that you be able to evaluate credit risk. Credit spread risk 3. .

Credit Spreads • The yield spread between Treasury and non-Treasury bonds that are identical in all respects except credit rating is referred to as the credit or quality spread. .

Credit Spreads • A credit spread or quality spread is the yield spread between a non-Treasury security and a Treasury security that are ‗‗identical in all respects except for credit rating.‘‘ • Some market participants argue that credit spreads between corporates and Treasuries change systematically because of changes in economic prospects—widening in a declining economy (‗‗flight to quality‘‘) and narrowing in an expanding economy. .

Credit Spreads • Credit spreads between Treasury and corporate bonds change systematically with changes in the overall economy. – Credit spreads widen (narrow) in a declining (expanding) economy. – Historical examples – Exhibit 4 shows the changes in credit spreads since 1919 • The spread is measured as the difference between the Baa and Aaa rated corporate debt • The relationship between macro-economic conditions and yield spread is clearly shown in the exhibit .

Credit Spreads .

This is referred to as the recovery rate. The percentage of a population of bonds that is expected to default is called the default rate. A default does not mean the investor loses the entire amount invested.Credit Risk: Default Risk • Default risk is the risk that the issuer will fail to satisfy the terms of the bond obligation with respect to the timely payment of principal and interest. • • . a percentage of the investment may be recovered.

This is the risk premium.Credit Risk: Credit Spread Risk Even if a bond issue does not go into default. . So even if interest rate do not change. The risk premium is also referred to as the yield spread. Recall that as the required yield increases. there is the risk that the market value of the bond will fall because the return demanded by the market has increased. The yield on a bond is made up of two components: The yield on a similar default (risk-free) bond A premium above the yield on a default-free bond to compensate for the additional risk of the bond. it is possible for a bond to fall in value if the level of credit risk spread increases. the price of a bond falls.

S. Treasury security.Credit Risk: Credit Spread Risk (continued) • – In the U. the Treasury security with the same maturity as the risky bond being evaluated is considered to be risk-free. etc. utilities.e. This risk is unique for individual companies. financial services. The risk premium or yield spread of a similar maturity bond is the difference between the yield of the bond and the comparable U. . • – The risk that the price an issuer‘s bonds will decline due to an increase in the credit spread is called the credit spread risk. That is why bond analysts will focus on understanding the unique risks of individual sectors (i. autos.) • The credit spread trends to increase during recessions and decrease during economic expansions. as well as for entire industries and sectors.S.

which also tends to cause price declines. a change by Standard & Poor‘s from a B to a CCC rating. the market anticipates downgrades by bidding down prices prior to the actual rating agency announcement. agencies often place them on a ―credit watch‖ status. • • . Downgrades are usually accompanied by bond price declines. In some cases. Before bonds are downgraded.Credit Risk: Downgrade Risk • Downgrades result when rating agencies lower their rating on a bond — for example.

• Third-party ratings such as Standard and Poor's (S&P).Credit Risk: Downgrade Risk • Bond Ratings: The bond's credit rating is the first indication of the bond's quality. and Fitch assign ratings to bonds. Moody's. Investment grade bonds are less likely to have their ratings downgraded or to default than non-investment grade bonds. • • While investment grade bonds may also be downgraded or default. which reflect their evaluation of the creditworthiness of an issuer. . a bond with a higher rating is less likely to experience a downgrade or default.

may be insured by third parties. Some bonds. such as municipal bonds. Rating services help to evaluate the creditworthiness of bonds.Credit Risk: Downgrade Risk • The quality of any bond is based on the issuer's financial ability to make interest payments and repay the loan in full at maturity. • .

Credit Risk: Downgrade Risk .

Credit Risk: Bond Ratings • The bond market can be divided into two sectors: the investment grade and noninvestment grade markets as summarized below: .

• . The table can be used to approximate downgrade risk and default risk. This is simply a table constructed by the rating agencies that shows the percentage of issues that were downgraded or upgraded in a given time period.Credit Risk: Bond Ratings • A popular tool used by managers to gauge the prospects of an issue being downgraded or upgraded is a rating transition matrix.

A liquid market is generally defined by a small bid-ask spread which does increase materially for large transactions. where the indication is revealed by a recent transaction. • The primary measure of liquidity is the size of the spread between the bid price (what the dealer is willing to pay) and the ask price (what the dealer is willing to sell). • .Liquidity Risk • Liquidity risk is the risk that the investor will have to sell the bond below its indicated value.

Exhibit 5 shows bid-ask spreads for a single security. • • . This liquidity measure is called the market bid-ask spread.Liquidity Risk • Bid-ask spreads are computed by looking at the best bid and lowest ask.

Liquidity Risk .

they are likely required to periodically mark the position to the market.Liquidity Risk • Marking Positions to Market: – Liquidity risk is not a great concern for noninstitutional investors who will be holding the position to maturity. – However. the highest bid might be a low price take would result weak reported performance. . With a bond that has low liquidity. even if an institutional investor intends to hold the security until maturity.

the exit or entry of a major investor can decrease or increase the relative amount of liquidity for an issue. the supply and demand dynamics can cause bid-ask spreads to change. . For instance. which result in changes in liquidity risk. – Because new offerings and products are being created.Liquidity Risk • Changes in Market Liquidity: – Bid-ask spreads change over time.

Inflation Risk • Inflation or purchasing power risk arises from the decline in the value of a bond‘s cash flows due to inflation. Inflation volatility is a closely watched measure. • .

the greater the value (price) of an option. • • . Therefore. all things equal. changing yield volatility affects the price of a bond with an embedded option – The greater the expected yield volatility.Volatility Risk • Volatility risk is the risk that the price of a bond with an embedded option will decrease when expected yield volatility changes. Basic option valuation concept: The price of an option increases with more volatility of the underlying asset.

If expected yield volatility increases. the price of an embedded call option will increase – resulting in a decrease in the price of a callable bond. . If expected yield volatility decreases.Volatility Risk • – The price of a callable bond is equal to the price of an option-free bond minus the price of an embedded call option. the price of an embedded put option will decrease – resulting in a decrease in the price of a putable bond. • – The price of a putable bond is equal to the price of an option-free bond plus the price of an embedded put option. all else the same. all else the same.

Volatility Risk • The risk that the price of a bond with an embedded option will decline when expected yield volatility changes is called volatility risk. • Below is a summary of the effect of changes in expected yield volatility on the price of callable and putable bonds: .

Event Risk • Occasionally an issuer is unable to make either interest or principal payments because of unexpected events. utilities. such as a hurricane or industrial accident A corporate takeover or restructuring that prevents the issuer from making timely payment A regulatory change that delays or prevents an issuer from being able to make payment • • EPA or ERISA regulatory changes New rules for financial services. such as – – – A natural catastrophe or disaster. or insurance companies could impact the ability to make payment .

as the result of the actions of a foreign government. political change. there may be either a default or an adverse price change even in the absence of a default – Currency revaluations. or war can result in a change in credit risk • Sovereign risk has two components: – – Unwillingness of a foreign government to pay principal or interest The inability of a foreign government to pay .Sovereign Risk • Sovereign risk is the risk that.

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