Investments 3A - Risks Associated with Investing in Bonds

Summary of Risks Associated with Bond Investing

  • Investments in bonds are subject to various risks that can impact the total return and the value of the portfolio. The specific risks identified are:

    • Interest rate risk

    • Call prepayment risk

    • Yield curve risk

    • Reinvestment risk

    • Credit risk

    • Liquidity risk

    • Exchange rate risk

    • Volatility risk

    • Inflation or purchasing power risk

    • Event risk

    • Sovereign risk

Key Principles of Interest Rate Risk

  • Inverse Relationship: The price of a typical bond changes in the opposite direction to the change in interest rates or yields. When interest rates rise, the price of the bond falls.

  • Definition: Interest rate risk is the risk that the price of a bond fluctuates with market interest rates. It is the risk faced by an investor that the price of a bond held in a portfolio would decline if market interest rates rise.

  • Pricing Relative to Par:

    • A bond trades at a price equal to par value when the coupon rate is equal to the yield required by the market: Coupon Rate=Yield Required by Market→Price=Par Value\text{Coupon Rate} = \text{Yield Required by Market} \rightarrow \text{Price} = \text{Par Value}

    • A bond trades below par (at a discount) if the coupon rate is lower than the yield required by the market: \text{Coupon Rate} < \text{Yield Required by Market} \rightarrow \text{Price} < \text{Par Value (Discount)}

    • A bond trades above par (at a premium) if the coupon rate is higher than the yield required by the market: \text{Coupon Rate} > \text{Yield Required by Market} \rightarrow \text{Price} > \text{Par Value (Premium)}

Factors Influencing Interest Rate Sensitivity

  • Ceteris Paribus Assumptions:

    • Impact of Maturity: The longer the bond maturity, the greater the bond price sensitivity to changes in interest rates.

    • Impact of Coupon Rate: The lower the coupon rate, the greater the bond sensitivity to changes in interest rates.

    • Zero-Coupon Bonds: These bonds have greater price sensitivity to interest rate changes than same-maturity bonds bearing a coupon rate and trading at the same yield.

    • Impact of Embedded Options: The value of a bond with embedded options changes based on how the value of the option itself changes in response to interest rate movements.

      • Price of a Callable Bond=Price of the Option-free Bond−Price of Embedded Call Option\text{Price of a Callable Bond} = \text{Price of the Option-free Bond} - \text{Price of Embedded Call Option}

      • The call option is subtracted because it is a benefit to the issuer and a disadvantage to the bondholder.

    • Impact of Yield Level: The higher the bond's yield, the lower the price sensitivity.

Interest Rate Risk for Floating Rate Securities

  • Coupon Adjustments: For a floating security, the coupon rate is adjusted periodically based on a market reference rate plus a set quoted margin.

  • Price Fluctuation Factors: The price of a floating rate security fluctuates based on three primary factors:

    1. The longer the time to the next coupon reset date, the greater the potential price fluctuation.

    2. Changes in the margin demanded by investors in the market.

    3. Cap Risk: Floating rate securities typically have a maximum coupon limit (cap). If the reset formula results in a rate above the cap, the coupon is set at the cap rate. This below-market coupon causes the security's price to decline.

Quantitative Measurement of Interest Rate Risk (Duration)

  • Rate Shock: Defined as the change in the yield in basis points.

  • Approximate Percentage Price Change Example (Bond ABC):

    • Current Price: 9090

    • Yield: 6%6\%

    • Rate Shock: Increase of 2525 basis points (to 6.25%6.25\%\n * Valuation Model Result: Estimated price of 8888

    • Primary Calculation:

      • Percentage Change=Current Price−Previous PricePrevious Price\text{Percentage Change} = \frac{\text{Current Price} - \text{Previous Price}}{\text{Previous Price}}

    • Interpretation of 1 Basis Point Shock: The price will decline 8.889%8.889\%, per one basis point change in yield (note: based on specific model valuation provided in class).

    • Yield Decline Scenario: If the yield declines from 6%6\% to 5.75%5.75\% (2525 basis points shock), the valuation model predicts the price will increase to 92.792.7.

  • Effective Duration Formula:

    • Duration=Price if Yields Decline−Price if Yields Rise2×(Initial Price)×(Change in Yield in Decimal)\text{Duration} = \frac{\text{Price if Yields Decline} - \text{Price if Yields Rise}}{2 \times (\text{Initial Price}) \times (\text{Change in Yield in Decimal})}

    • Example Application:

      • Price if yields decline (PdownP_{down}): 92.792.7

      • Price if yields rise (PupP_{up}): 88.0088.00

      • Initial Price (P0P_0): 9090

      • Change in Yield (Δy\Delta y): 0.00250.0025

    • Result: Average percentage price change equals 0.10440.1044 or 10.44%10.44\%. This means that for a 100100 basis point change in yield, the average percent price change is 10.44%10.44\%.

  • Dollar Duration:

    • Dollar Duration=Value of the Bond (Market Price)×Duration\text{Dollar Duration} = \text{Value of the Bond (Market Price)} \times \text{Duration}

Yield Curve Risk

  • Yield Curve: The relationship between yield and maturity.

  • Yield Curve Risk: Refers to the risk that portfolios have different exposures to how the yield curve shifts.

  • Shift Types: Comparisons between parallel shifts and non-parallel shifts (refer to textbook illustrations for detailed visualization).

Call and Prepayment Risks

  • Definition: A call provision allows the issuer to redeem the bond before maturity.

  • Disadvantages for Investors:

    1. Uncertainty: The cash flow pattern is unknown because it is unclear when the bond will be called.

    2. Reinvestment Risk: Issuers call bonds when interest rates fall below the coupon rate; investors must then reinvest at these lower prevailing rates.

    3. Price Compression: The price appreciation potential is limited compared to an option-free bond because the market recognizes the issuer will call the bond if the price rises too high.

  • MBS and ABS: These disadvantages apply to Mortgage-Backed Securities (MBS) and Asset-Backed Securities (ABS) where borrowers can prepay principal (Prepayment Risk).

Reinvestment Risk

  • Definition: This is the risk that proceeds received from interest and principal payments must be reinvested at a lower interest rate than the security that generated the proceeds.

  • Drivers:

    • Occurs when an issuer calls a bond to lower interest expenses after rates decline.

    • Occurs when an investor relies on the yield of a bond as a specific measure of return, but cannot reinvest coupons at that same yield.

Credit Risk Categories

  • Default Risk: The risk that the issuer fails to satisfy the terms of the obligation regarding timely payment of interest and principal.

    • Default Rate: The percentage of a population of bonds expected to default.

    • Recovery Rate: The percentage of the investment recovered after a default occurs.

  • Credit Spread Risk:

    • Yield Spread: The risk premium.

    • Credit Spread: The portion of the yield spread attributable specifically to default risk.

    • Risk definition: The risk that an issuer's debt value declines due to an increase in credit spreads.

  • Downgrade Risk:

    • Credit Rating: An indication of potential default risk by companies (rating agencies). High grade indicates low credit risk.

    • Investment Grade vs. Non-investment Grade: Critical distinction for portfolio inclusion.

    • Risk definition: An unanticipated downgrade increases credit spreads and results in a price decline.

Liquidity Risk and Market Valuation

  • Liquidity Risk: The risk that an investor must sell a bond below its indicated value revealed by recent transactions.

  • Bid-Ask Spread: The primary measure of liquidity.

    • Bid Price: The price at which a dealer is willing to buy.

    • Ask Price: The price at which a dealer is willing to sell.

    • Relationship: The wider the spread, the greater the liquidity risk.

  • Marking to Market: Revaluing a security/portfolio based on current market prices. Managers typically solicit bids from multiple brokers/dealers to determine the bid price used for valuation.

  • Liquidity Volatility: Bid-ask spreads change over time; unexpected interest rate changes can cause spreads to widen.

Exchange Rate, Inflation, and Volatility Risks

  • Exchange Rate / Currency Risk: The risk of receiving less domestic currency when payments are made in a foreign currency.

  • Inflation / Purchasing Power Risk: Arises from the decline in the value of a security's cash flow due to inflation.

  • Volatility Risk: Specifically affects bonds with embedded options. It is the risk that the price will decline when expected yield volatility changes.

    • Expected Volatility: In common stock, this is price volatility; in bonds, it is yield volatility.

    • Bond Pricing with Volatility:

      • Price of Callable Bond=Price of Option-Free Bond−Price of Embedded Call Option\text{Price of Callable Bond} = \text{Price of Option-Free Bond} - \text{Price of Embedded Call Option}

      • Price of Putable Bond=Price of Option-Free Bond+Price of Embedded Put Option\text{Price of Putable Bond} = \text{Price of Option-Free Bond} + \text{Price of Embedded Put Option}

    • Impact Table:

      • Callable Bond: Price declines when expected yield volatility increases (increases the value of the subtrahend call option).

      • Putable Bond: Price declines when expected yield volatility decreases.

Event Risk and Sovereign Risk

  • Event Risk: Dramatic changes in an issuer's ability to pay due to:

    1. Natural disasters or industrial accidents.

    2. Takeovers or corporate restructurings.

    3. Regulatory changes (Regulatory Risk).

    4. Events resulting in credit downgrades (Downgrade risk).

    5. Contagion events affecting other issuers.

  • Sovereign Risk: The risk that foreign government actions cause a default or adverse price change.

    • Form 1: Unwillingness of the government to pay.

    • Form 2: Inability to pay due to unfavorable economic conditions.

Questions & Discussion

  • Upcoming Schedule:

    • Prepare for Chapter 5 next Thursday.

    • Tutorial scheduled for next week Tuesday.

    • Attendance register must be signed.

    • Closing: "Enjoy your day and the rest of the week."