RISK ASSOCIATED WITH INVESTING IN FIXED

INCOME SECURITIES

Dr. Ika Pratiwi Simbolon

References:

Fabozzi, F. J., and Mann, S. V., (2005). The Handbook of Fixed Income Securities. McGraw-Hill Companies
Learning Outcomes
• Be able to understand the interest rate risk.
• Be able to understand the reinvestment risk.
• Be able to understand the timing or call risk.
• Be able to understand the yield curve or maturity risk.
• Be able to understand the inflation or purchasing risk.
• Be able to understand the liquidity risk.
• Be able to understand the exchange rate or currency risk.
• Be able to understand the volatility risk.
• Be able to understand the political or legal risk.
• Be able to understand the event risk.
• Be able to understand the sector risk.
• Be able to understand the other risks.
MARKET, OR INTEREST-RATE, RISK
The price of a typical fixed income security
moves in the opposite direction of the
change in interest rates:

As interest rates rise (fall), the price of a

fixed income security will fall (rise).
 For an investor who plans to hold a fixed
income security to maturity, the change in its
price before maturity is not of concern;

however, for an investor who may have to

sell the fixed income security before the
maturity date, an increase in interest rates
will mean the realization of a capital loss.
 This risk is referred to as market
risk, or interest-rate risk, which is
by far the biggest risk faced by an
investor in the fixed income market.
REINVESTMENT RISK
The cash flows received from a security are
usually reinvested.

The variability in the returns from reinvestment

from a given strategy due to changes in market
rates is called reinvestment risk.

The risk here is that the interest rate at which

interim cash flows can be reinvested will fall.
TIMING, OR CALL, RISK
Bonds may contain a provision that allows
the issuer to retire, or “call,’’ all or part of the
issue before the maturity date.

The issuer usually retains this right to

refinance the bond in the future if market
interest rates decline below the coupon rate.
From the investor’s perspective, there
are three disadvantages of the call
provision.

First, the cash-flow pattern of a callable

bond is not known with certainty.
 Second, because the issuer may call the
bonds when interest rates have dropped, the
investor is exposed to reinvestment risk.

That is, the investor will have to reinvest the

proceeds received when the bond is called
at lower interest rates.
 Finally, the capital appreciation
potential of a bond will be reduced
because the price of a callable bond
may not rise much above the price at
which the issuer may call the bond.
CREDIT RISK
The credit risk of a bond includes

1. The risk that the issuer will default on its

obligation (default risk).
2. The risk that the bond’s value will decline
and/or the bond’s price performance will be
worse than that of other bonds against
which the investor is compared.
 A credit rating is a formal opinion given by a
specialized company of the default risk faced by
investing in a particular issue of debt securities.

The specialized companies that provide credit

ratings are referred to as “rating agencies.”

The three nationally recognized rating agencies in

the United States are Moody’s Investors Service,
Standard & Poor’s Corporation, and Fitch Ratings.
 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 to its bonds.

An “upgrade” occurs when there is an

improvement in the credit quality of an issue;
a “downgrade” occurs when there is a
deterioration in the credit quality of an issue.
YIELD-CURVE, OR MATURITY, RISK
In many situations, a bond of a given
maturity is used as an alternative to another
bond of a different maturity.

An adjustment is made to account for the

differential interest-rate risks in the two
bonds.
However, this adjustment makes an assumption
about how the interest rates (i.e., yields) at
different maturities will move.

To the extent that the yield movements deviate

from this assumption, there is yield-curve, or
maturity, risk.
INFLATION, OR PURCHASING POWER, RISK

Inflation risk, or purchasing power risk, arises

because of the variation in the value of cash flows
from a security due to inflation.

For example, if an investor purchases a five-year

bond in which he or she can realize a coupon rate
of 7%, but the rate of inflation is 8%, then the
purchasing power of the cash flow has declined.
LIQUIDITY RISK

Liquidity risk is the risk that the investor will have

to sell a bond below its true value where the true
value is indicated by a recent transaction.

The primary measure of liquidity is the size of the

spread between the bid price and the ask price
quoted by a dealer.

The wider the bid-ask spread, the greater is the

liquidity risk.
 From the perspective of the market overall, the
bid-ask spread can be computed by looking at the
best bid price (high price at which one of the
dealers is willing to buy the security) and the
lowest ask price (lowest offer price at which one of
the dealers is willing to sell the security).

This liquidity measure is called the market bid-ask

spread.
 For investors who plan to hold a bond until
maturity and need not mark a position to market,
liquidity risk is not a major concern.

An institutional investor who plans to hold an issue

to maturity but is periodically marked to market is
concerned with liquidity risk.

By marking a position to market, it is meant that

the security is revalued in the portfolio based on its
current market price.
EXCHANGE-RATE, OR CURRENCY, RISK

Suppose that an investor purchases a bond whose

payments are in Japanese yen.

If the yen depreciates relative to the U.S. dollar,

then fewer dollars will be received.

The risk of this occurring is referred to as

exchange-rate risk, or currency risk.
 Of course, should the yen
appreciate relative to the U.S.
dollar, the investor will benefit
by receiving more dollars.
VOLATILITY RISK

The price of a bond with an embedded option

depends on the level of interest rates and factors
that influence the value of the embedded option.

One of the factors is the expected volatility of

interest rates.

Specifically, the value of an option rises when

expected interest-rate volatility increases.
 In the case of a callable bond or mortgage-
backed security, because the investor has
granted an option to the borrower, the price
of the security falls because the investor has
given away a more valuable option.

The risk that a change in volatility will

adversely affect the price of a security is
called volatility risk.
POLITICAL OR LEGAL RISK

A regulatory authority can conclude that a given security is

unsuitable for investment entities that it regulates.

These actions can adversely affect the value of the

security.

Similarly, it is also possible that a legal or regulatory action

affects the value of a security positively.

The possibility of any political or legal actions adversely

affecting the value of a security is known as political or
legal risk.
EVENT RISK

Occasionally, the ability of an issuer to make

interest and principal payments is seriously and
unexpectedly changed by
(1) a natural or industrial accident or
(2) a takeover or corporate restructuring.

These risks are referred to as event risk.

SECTOR RISK

Bonds in different sectors of the market respond

differently to environmental changes because of a
combination of some or all of the preceding risks,
as well as others.

The possibility of adverse differential movement of

specific sectors of the market is called sector risk.
OTHER RISKS

The various risks of investing in the fixed income

markets reviewed in this chapter do not represent
the entire range of risks.

In the marketplace, it is customary to combine

almost all risks other than market risk (interest-rate
risk) and refer to it as basis risk.
 “You can…”

Thank you fellas

God bless, Good Luck and With Love,

Dr. Ika Pratiwi Simbolon