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RISKS ASSOCIATED WITH BONDS

RISKS RELATED TO BONDS

Interest Rate Risk Maturity Risk Coupon Rate Risk Reinvestment Risk Default Risk Credit Spread Risk Downgrade Risk Event Risk

INTEREST RATE RISK


The price on a typical bond will change in the opposite direction to changes in the market yields. When the interest rates rises, the bonds price will fall; when interest rates fall, bonds prices will rise. The risk an investor faces is that the price of a bond will decline if market interest rates rise.

INTEREST RATE RISK


Which bonds have and error in their reported price?
Bond/Issuer Coupon Rate A 7.75% B 6.75% C 0.00% D 5.50% E 8.50% F 4.50% G 6.25% Maturity (Years) 16 4 10 20 18 6 25 Market Rate Price (% of Par) 6.00% 114.02% 7.00% 99.14% 5.00% 102.10% 5.90% 104.15% 8.50% 100.00% 4.00% 96.50% 6.25% 103.45%

MATURITY RISK

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

COUPON RATE RISK

All other factors constant, the lower the coupon rate, the greater the bonds price sensitivity to changes in market rates.

MATURITY AND COUPON RATE RISK


A report shows that the market yield for the bonds below are the same. Which bond has the greatest interest rate risk and which has the least interest rate risk?
Bond/Issuer A B C D Coupon Rate 5.25% 6.50% 4.75% 8.50% Maturity (Years) 15 12 20 10

MARKET YIELD RISK

If two bonds have the same characteristics, the one trading at a lower market rate is more sensitive to changes in the market rate. Price sensitity is higher when the level of market rates is low, and price sensitivity is lower when the level of market rates is high.

MARKET YIELD RISK

Which of the following bonds has the greatest market yield risk? Which one has the lowest credit rating?

Bond/Issuer Coupon Rate A 6.5% B 6.5% C 6.5%

Maturity 12 12 12

Market Rate 7.00% 8.00% 9.00%

REINVESTMENT RISK

Reinvestment Risk is the possibility that the proceeds from payments of interest and principal will be reinvested at a lower market rates than the original invesment. Which of the following bonds has higher reinvestment risk?
Bond/Issuer Coupon Rate A 0.0% B 8.0% C 10.0% Maturity 5 5 5 Market Rate 5.00% 12.00% 10.00%

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 Default Rate is the percentage of a population of bonds that is expected to default . Recovery Rate is the percentage of a default investment that can be recovered.

DOWNGRADE RISK

A credit rating is an indicator of the potencial default risk associated with a bond A credit rating is an assessment of an issuers ability to meet the payment of principal and interest in accordance with the term of indenture. Bond market can be divided in: Investment grade AAA, AA, A and BBB Non-Investment grade Below BBB

DOWNGRADE RISK
Rating Agencies following up the credit quality of bonds can reassign a different credit rating. An improvement in the credit quality is rewarded with a better credit rating, and its referred to as an UPGRADE. A deterioration in the credit quality is penalized by the assignment of a lower credit rating, and its referred to as a DOWNGRADE.

CREDIT SPREAD RISK



Credit Spread Risk (or Yield Spread Risk) is the Risk Premium for a bond rating class is referred to Recall that risk premium is the yield above the riskfree rate to compensate for the additional risk taken.

Credit Spread Risk YTM Risk Free Rate

Credit Spread Risk is measured in basis points Credit spread risk changes with industry, sector, and economic fluctuations. An anticipated downgrading increases the credit spread and results in a decline of the bonds price

EVENT RISK

Deterioration on the ability of an issuer to make interest and principal payments due to unexpected events outside of the issuer control. Natural disaster Takeovers Regulatory Changes

YIELD CURVE (Term Structure of Interest Rates)

Yield Curve

plot of maturity vs. yield (spot rates) slope of curve indicates relationship between maturity and yield. A spot rate is the rate used to discount a single expected future cash flow.

Yield Curve: An Example


Term (years)
0.25 2.00 5.00 10.00 30.00

Interest Rate (%)


3.62 4.34 5.07 5.54 5.86

BOND VALUATION
CF1 = i x P CF2= i x P CF3 = i x P t= 1 t= 2 t= 2 t= n CFn = i x P + P t= 0

Bond Price = ?

Bond Price

i P iP i P i P P ... (1 r)1 (1 r)2 (1 r)3 (1 r)n


i P P (1 r)t (1 r)n t 1
n

Bond Price

P = Principal i = coupon rate r = market rate (market yield) i x P = Coupon Payment

flat yield curve


yield

maturity

yields similar for all maturities

upward sloping yield cuve


yield

maturity

yields rise w/ maturity (common)

downward sloping (inverted) yield curve


yield

maturity

yield falls w/ maturity (rare)

humped
yield

maturity

intermediate yields are highest May 2000

BOND VALUATION TRADITIONAL APPROACH


Traditional approach to bond valuation is to discount every cash flow of a fixed income security using the same interest rate or discount rate.

C C C P Value 1 2 n (1 y) (1 y) (1 y) (1 y) n

where: C = coupon payment P = principal payment y = market yield (typically Yield to Maturity,YTM) n = number of periods over life of bond

BOND AS A PACKAGE OF ZEROES COUPON BONDS

Any bond can be thought of as a package of zero-coupon bonds. Another way to view a 4-year, every 6 months, 6% coupon bond is as a package of zero-coupon bonds.

C C

C C

C C

C C

The 4-year security should be viewed as a package of 8 zerocoupon instruments that mature every six months for the next four years.

DETERMINING SPOT RATES

A spot rate is the rate used to discount a single expected future cash flow.

Suppose you observe the following data for three government bonds (default risk close to zero) :
Maturity 1 Year 2 Years 3 Years YTM Coupon Rate 3.6% 0.0% 3.8% 3.8% 4.0% 4.0% Price(% of par) 96.64% 100% 100%

In order to find the spot rates from this data, we need to strip the coupons from the bonds.

DETERMINING SPOT RATES


Maturity 1 Year 2 Years 3 Years YTM Coupon Rate 3.6% 0.0% 3.8% 3.8% 4.0% 4.0% Price(% of par) 96.64% 100% 100%

Cash flow timeline from the stripped cash flows is as follows:


0 1-year bond 2-year bond 3-year bond -96.6463 -100.000 -100.000 1 2 3

+100 +3.8 +4 +103.8 +4 +104

DETERMINING SPOT RATES

Since these bonds all have the same issuer, all cash flows received at t=1, must be discounted at the same rate. The 1-year zero coupon bond has only one cash flow, we can use its YTM as the discount factor for other t=1 cash flows, i.e. use 3.62% as the one-year spot rate Z1. (Z1 = 3.62%)

NOTE:

This approach to create a theoretical spot rate curve is called bootstrapping.

DETERMINING SPOT RATES

We can use the one-year spot rate to discount the cash flows for the 2-year bond as follows: 100.000 = 3.8/(1 + Z1)1 + 103.8/(1 + Z2)2 100.000 = 3.8/(1.0362)1 + 103.8/(1 + Z2)2

100.000 3.93756 = 103.8/(1 + Z2)2


96.06244 = 103.8/(1 + Z2)2

1.080547194 = (1 + Z2)2
1.03949372 = 1 + Z2 Z2 = 3.949372%

DETERMINING SPOT RATES

We can use the one- and two-year spot rates to discount the cash flows for the 3-year bond as follows: 100.000 = 4/(1 + Z1)1 + 4/(1 + Z2)2 + 104/(1 + Z3)3 100.000 = 4/(1.0362)1 + 4/(1.03949372)2 + 104/(1 + Z3)3 1.125079487 = (1 + Z3)3 Z3 = 4.0066406%

VALUING BONDS WITH SPOT RATES

We can use the spot rates to value other bonds issued by the same entity or by adding a credit spread to value bonds issued by another entity. Recall, Z1 = 3.62%, Z2 = 3.949%, Z3 = 4.007% Use these spots rates to calculate the value of a three-year, annual-pay, 5% coupon bond with the same risk characteristics as the previous bond. Bond Value = 5/(1 + Z1)1 + 5/(1 + Z2)2 + 105/(1 + Z3)3 102.778 = 5/(1.0362)1 + 5/(1.03949)2 + 105/(1.04007)3

PLEASE DO NOT FORGET WEDNESDAY 9th MID-TERM EXAM 9PM TO 10:30PM

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