Copyright FinQuiz.com. All rights reserved.

2013, Study Session # 15, Reading # 53

RISKS ASSOCIATED WITH INVESTING IN BONDS

Risks Associated with Investing in Bonds
Interest Rate Risk
Effect of changes in
prevailing market
interest rate on
Bond values.
As i B
p
.
Yield Curve Risk
Risk arising from
the possibility of
changes in the
shape of yield
curve.
Call Risk
Bond may be called when
i & amount will have to
be reinvested at a lower
rate.
Non-Callable Bond
No call risk.
Call protection
Reduced call risk.
Higher volatility
Higher call risk.
Prepayment Risk
Prepayments
as i hence
prepayments
have to reinvest
at new lower rate.
Higher volatility
Higher Risk
Reinvestment Risk
As i, cash flows
are reinvested at
lower rate &
hence return.
Non-Callable zero
Coupon Bond
has no proceeds
to be reinvested
& hence has no
reinvestment risk.

Credit Risk
Creditworthiness of
issuer will
deteriorate causing
required return to
rise & securitys
value to fall.
Liquidity Risk
Immediate
sale of security
will result in a
price below
fair value.
Liquidity
price
required
yield.
Event Risk
Risks other than
that of financial
markets. E.g.,
natural disasters. &
corporate
takeovers.
Volatility Risk
Present for fixed-
income securities,
with embedded
options.
Higher volatility
higher risk.
Inflation Risk
Unexpected inflation
risk or purchasing
power risk.
Uncertainty about the
purchasing power of
securitys cash flows.
Sovereign Risk
Change in govts
attitudes & policies
towards the repayment
& servicing of debt.
Two Components
Countrys
ability to
repay.
Important in
most
defaults &
downgrades.
Govts willingness
to repay.

Relationship among Bonds
price, coupon rate &
required market yield
Mkt yield = Coupon rate Trade at par
Mkt yield > Coupon rate
Trade at
discount
Mkt yield < Coupon rate
Trade at
premium
1

Copyright FinQuiz.com. All rights reserved.
2013, Study Session # 15, Reading # 53







Effects of a bonds features on interest rate risk
Maturity
Higher maturity

Higher duration

Higher interest
rate risk.
Coupon rate
Higher coupon rate

Lower duration

Lower interest rate
risk.
Presence of embedded options
Call feature
It limits upside price movement
when i.
As i B
p
but not above call
price.
in B
p
is lesser relative to an
option free bond.
Put feature
It limits downside price
movement when i.
As i B
p
, but not below put
price.
in B
p
is lesser relative to an
option free bond.
Conclusion
Value of callable & putable
bond is less sensitive to
interest rate changes.
Duration
Measure of interest rate risk.
Measures price sensitivity of a security
to changes in interest rate.
Characteristic
Interest
rate risk
Duration
Maturity
Coupon
Add call
Add put


Relationship among option free bond
callable bond & option value
Value of callable bond
= value of option free
bond option value
As yield falls
Value of callable bond rise less relative to the
value of option free bond.
Difference b/w prices of callable & option-free
bond rises.

Disadvantages of a callable /
prepayable security
Uncertain
cash flow
stream.
Reinvestment risk
rises as interest rate
falls.
Less potential of
price appreciation.


Higher coupon
Call feature present.
Prepayment option
present.
Amortizing security.
Higher
reinvestment
Risk &
Lower interest
rate risk
2

Copyright FinQuiz.com. All rights reserved.
2013, Study Session # 15, Reading # 53
































Interest rate risk of floating rate securities
Reset Mechanism
Coupon rate is
periodically reset
based on a market
determined
reference rate.
Objective of Reset
Mechanism
To bring coupon
rate in line with the
current market
yield in order to sell
the bond at or near
the par value.
Consequence of
Reset Mechanism
Price of floating
rate security is
much less sensitive.
to changes in
market yield.
Impact of Reset
period
Longer (shorter)
the reset period

greater (less) the
interest rate risk at
any reset date.



Reasons of bond price differing
from par at coupon reset date
Cap Risk
If mkt yield rises
above cap,
security trades at
a discount to par
value.
Presence of cap
can increase
interest rate risk.
Fixing margin at issuance
Creditworthiness of
issuer may improve &
the security will trade at
a premium to par.
A change in the
markets required yield
premium for the firms
risk level will cause the
value of floater to differ
from par.

Duration
Measure of price
sensitivity of a security
to changes in yield.
Duration =

%

%

Duration for a portfolio of
bonds
Approximate % age in
portfolios value for a unit
(equal) in yields for all
bonds.
Duration
Zero Coupon
bond
Floater
Approximately
equal to its
years to
maturity.
Equal to the
fraction of a
year until the
next reset date.
Duration of amortizing securities
< Duration of non-amortizing
securities.

Yield Curve
Graph b/w
maturity & yield.
Parallel Shift yields on all bonds change
by the same amount.
Non-parallel Shift yields on different
bonds differ by different amount.
Yield Curve Risk
Risk of decreases in portfolio
value from changes in shape
of yield curve i.e., non-
parallel shifts
3

Copyright FinQuiz.com. All rights reserved.
2013, Study Session # 15, Reading # 53
































Credit Rating
Indicates relative probability of default.
Bond ratings are not an absolute measure of default risk.
Bond ratings provide relative probability of default across
companies & bonds.
Default
Issuer not making
timely interest &
principal payments.
Default Risk
The risk that payments
wont be made as
promised or scheduled.
Difference in
the priority of
bondholders
claim.
Reasons for
differences in
ratings of Bonds of
same Company
Difference
in collateral
Basis of Ratings
Financial strength of a
company.
Credit spread or default risk premium = yield of lower
rating bond of same maturity - yield on default free bond.
Downgrade Risk
Credit rating
agency will lower
a bonds rating.

Rating Upgrade
Credit rating agency
will increase a bonds
rating.

Credit Spread Risk
Even when the default free
rate hasnt changed, default
risk premium required in the
market for a given rating can
increase.
Credit spread required
yield Bonds price.

Liquidity Risk
Investors prefer more liquidity
hence higher yield is required
for less liquid securities.
Bid
Price that the
dealer is willing
to pay for a
security.
Ask
Price at which
dealer is willing
to sell a
security.
Importance of liquidity
even if security is to
be held till maturity
If liquidity is low,
periodic valuation
(marking to market) is
difficult because of:
Variations in
dealers bid prices.
Absence of dealers
bid prices.
Effects of decline in liquidity
on institutional investor
While periodic
reporting the prevailing
market price may
misstate the true value
of the security & can
reduce return or
performance.
In case of repo
agreement, lower
valuation of collateral
value can lead to a
higher cost of fund and
reduced portfolio
performance.
Bid-Ask spread
Difference b/w Bid & Ask.
It is an indication of the liquidity of the security
market.
As liquidity Bid-Ask spread.
S & P
AAA
AA+AA AA-
A
BBB
BB
B
CCC
CC
C
Investment
grade.
Junk
speculative or
high yield.
Moodys
Aa1 Aa2 Aa3
4

Copyright FinQuiz.com. All rights reserved.
2013, Study Session # 15, Reading # 53



Exchange Rate Risk
Actual cash flows from the
investment may be worth less in
domestic currency than were
expected.
Appreciation of domestic currency or
Depreciation of foreign currency
returns in domestic currency.
Volatility risk
For callable
Bond
Volatility will
rise.
For putable
Bond
Volatility will
fall.
Value of callable Bond = value of
option free Bond value of call
Value of putable Bond = value of
option free Bond + value of put
Value of
Yield volatility

Put
Call
Putable
Bond

Callable
Bond


Event Risk
Not related with
financial market
Disasters Corporate
Restructurings
Regulatory Issues.
5