Chapter 2 - Risks Associated with Investing in Bonds

Floating Rate Securities

A type of debt instrument that offers protection to investors during periods of very volatile interest rates. For example, when interest rates are rising, the interest paid on floating rate debentures is adjusted upwards every six months.

Credit Rating

A credit rating is an indicator of the potential default risk associated with a particular bond issue or issuer. It represents in a simplistic way the credit rating agency's assessment of an issuer's ability to meet the payment of principal and interest in accordance with the terms of the indenture.

Yield Curve

A graph showing the relationship between bond yields and maturities. Investors pay close attention to the yield curve as it provides an indication of where short term interest rates and economic growth are headed in the future. The yield curve is a graphical illustration of the relationship between interest rates and bond yields of various maturities, ranging from 3-month Treasury bills to 30-year Treasury bonds. The graph is plotted with the y-axis depicting interest rates, and the x-axis showing the increasing time durations.

Downgrade Risk

An unanticipated downgrading of an issue or issuer increases the credit spread and results in a decline in the price of the issue or the issuer's bonds. This risk is referred to as downgrade risk and is closely related to credit spread risk.

Key Rate Duration

Consequently, in theory, there is not one rate duration but a rate duration for each maturity. In practice, a rate duration is not computed for all maturities. Instead, the rate duration is computed for several key maturities on the yield curve and this is referred to as key rate duration. Key rate duration is therefore simply the rate duration with respect to a change in a ''key'' maturity sector. Vendors of analytical systems report key rate durations for the maturities that in their view are the key maturity sectors.

Disadvantages of Call Provisions for the Investor

Disadvantage 1: The cash flow pattern of a callable bond is not known with certainty because it is not known when the bond will be called. Disadvantage 2: Because the issuer is likely to call the bonds when interest rates have declined below the bond's coupon rate, the investor is exposed to reinvestment risk, i.e., the investor will have to reinvest the proceeds when the bond is called at interest rates lower than the bond's coupon rate. Disadvantage 3: The price appreciation potential of the bond will be reduced relative to an otherwise comparable option-free bond. (This is called price compression.)

Dollar Duration

Dollar Duration = Dollar change in bond price for a 1% (100 basis point) change in yield.

Recovery Rate

If a default occurs, this does not mean the investor loses the entire amount invested. An investor can expect to recover a certain percentage of the investment. This is called the recovery rate.

LIquidity Risk

Liquidity risk is the risk that the investor will have to sell a bond below its indicated value, where the indication is revealed by a recent transaction. The primary measure of liquidity is the size of the spread between the bid price (the price at which a dealer is willing to buy a security) and the ask price (the price at which a dealer is willing to sell a security). The wider the bid-ask spread, the greater the liquidity risk.

Event Risk

Occasionally the ability of an issuer to make interest and principal payments changes dramatically and unexpectedly because of factors including the following: 1. a natural disaster (such as an earthquake or hurricane) or an industrial accident that impairs an issuer's ability to meet its obligations 2. a takeover or corporate restructuring that impairs an issuer's ability to meet its obligations 3. a regulatory change These factors are commonly referred to as event risk.

Reinvestment Risk

Reinvestment risk is the risk that the proceeds received from the payment of interest and principal (i.e., scheduled payments, called proceeds, and principal prepayments) that are available for reinvestment must be reinvested at a lower interest rate than the security that generated the proceeds. When dealing with amortizing securities (i.e., securities that repay principal periodically), reinvestment risk is even greater.

Interest Rate Risk

Since the price of a bond fluctuates with market interest rates, the risk that an investor faces is that the price of a bond held in a portfolio will decline if market interest rates rise. This risk is referred to as interest rate risk and is the major risk faced by investors in the bond market. if interest rates increase → price of a bond decreases if interest rates decrease → price of a bond increases

Default Rate

Studies have examined the probability of issuers defaulting. The percentage of a population of bonds that is expected to default is called the default rate.

Yield Spread

The difference in yield between a credit-risky bond and a credit-risk-free bond of similar maturity. The yield on a bond is made up of two components: (1) the yield on a similar default-free bond issue and (2) a premium above the yield on a default-free bond issue necessary to compensate for the risks associated with the bond. The risk premium is referred to as a yield spread. In the United States, Treasury issues are the benchmark yields because they are believed to be default free, they are highly liquid, and they are not callable (with the exception of some old issues).

The Impact of the Yield Level

The higher a bond's yield, the lower the price sensitivity. The bond that trades at a lower yield is more volatile in both percentage price change and absolute price change, as long as the other bond characteristics are the same. An implication of this is that, for a given change in interest rates, price sensitivity is lower when the level of interest rates in the market is high, and price sensitivity is higher when the level of interest rates is low.

Credit Spread

The part of the risk premium or yield spread attributable to default risk is called the credit spread.

Interest Rate Risk for Floating-Rate Securities

The price of a floating-rate security will fluctuate depending on three factors. 1. First, the longer the time to the next coupon reset date, the greater the potential price fluctuation. 2. The second reason why a floating-rate security's price will fluctuate is that the required margin that investors demand in the market changes. 3. Finally, a floating-rate security will typically have a cap. Once the coupon rate as specified by the coupon reset formula rises above the cap rate, the coupon will be set at the cap rate and the security will then offer a below-market coupon rate and its price will decline. In fact, once the cap is reached, the security's price will react much the same way to changes in market interest rates as that of a fixed-rate coupon security. This risk for a floating-rate security is called cap risk.

Credit Spread Risk

The price performance of a non-Treasury bond issue and the return over some time period will depend on how the credit spread changes. If the credit spread increases, investors say that the spread has ''widened'' and the market price of the bond issue will decline (assuming U.S. Treasury rates have not changed). The risk that an issuer's debt obligation will decline due to an increase in the credit spread is called credit spread risk.

Credit Risk

The probability that the borrower will fail to pay some of the interest or principal. An investor who lends funds by purchasing a bond issue is exposed to credit risk. There are three types of credit risk: 1. default risk 2. credit spread risk 3. downgrade risk

Prepayment Risk

The same disadvantages apply to mortgage-backed and asset-backed securities where the borrower can prepay principal prior to scheduled principal payment dates. This risk is referred to as prepayment risk, the risk that the borrower will prepay the mortgage when interest rates fall.

Yield Curve Risk

The yield curve risk is the risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument. When market yields change, this will impact the price of a fixed-income instrument. When market interest rates, or yields, increase, the price of a bond will decrease, and vice versa. Changes in the yield curve are based on bond risk premiums and expectations of future interest rates.

Duration

There is a special name given to this estimate of the percentage price change for a 100 basis point change in yield. It is called duration. As can be seen, duration is a measure of the price sensitivity of a bond to a change in yield. So, for example, if the duration of a bond is 10.44, this means that the approximate percentage price change if yields change by 100 basis points is 10.44%. **It is important to note that the computed duration of a bond is only as good as the valuation model used to get the prices when the yield is shocked up and down. If the valuation model is unreliable, then the duration is a poor measure of the bond's price sensitivity to changes in yield.

Sovereign Risk

When an investor acquires a bond issued by a foreign entity (e.g., a French investor acquiring a Brazilian government bond), the investor faces sovereign risk. This is the risk that, as a result of actions of the foreign government, there may be either a default or an adverse price change even in the absence of a default. Sovereign risk consists of two parts. First is the unwillingness of a foreign government to pay. A foreign government may simply repudiate its debt. The second is the inability to pay due to unfavorable economic conditions in the country. Historically, most foreign government defaults have been due to a government's inability to pay rather than unwillingness to pay.

Bond Features that Affect Interest Rate Risk

1. The Impact of Maturity All other factors constant, the longer the bond's maturity, the greater the bond's price sensitivity to changes in interest rates. 2. The Impact of Coupon Rate A property of a bond is that all other factors constant, the lower the coupon rate, the greater the bond's price sensitivity to changes in interest rates. 3. The Impact of Embedded Options The value of a bond with embedded options will change depending on how the value of the embedded options changes when interest rates change. For example, we will see that as interest rates decline, the price of a callable bond may not increase as much as an otherwise option-free bond (that is, a bond with no embedded options).

Call Risk

Because of these three disadvantages faced by the investor, a callable bond is said to expose the investor to call risk, the risk to bondholders that a bond may be called away from them before maturity.

Bond Ratings

Bonds rated triple A (AAA or Aaa) are said to be prime grade; double A (AA or Aa) are of high quality grade; single A issues are called upper medium grade, and triple B are lower medium grade. Lower-rated bonds are said to have speculative grade elements or to be distinctly speculative grade. Bond issues that are assigned a rating in the top four categories (that is, AAA, AA, A, and BBB) are referred to as investment-grade bonds. Issues that carry a rating below the top four categories are referred to as non-investment-grade bonds or speculative bonds, or more popularly as high yield bonds or junk bonds. Thus, the bond market can be divided into two sectors: Investment Grade Bonds - AAA, AA, A, and BBB Non-Investment Grade Bonds (Speculative/High Yield) - Below BBB

Default Risk

Default risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal.

Rate Duration

It is possible to determine the percentage change in the value of a portfolio if only one maturity's yield changes while the yield for all other maturities is unchanged. This is a form of duration called rate duration, where the word ''rate'' means the interest rate of a particular maturity. So, for example, suppose a portfolio consists of 40 bonds with different maturities. A ''5-year rate duration'' of 2 would mean that the portfolio's value will change by approximately 2% for a l00 basis point change in the 5-year yield, assuming all other rates do not change.

Rating Agencies

Rating agencies charge the issuers of debt securities a fee for assessing default risk. There are three rating agencies in the United States: Moody's Investors Service, Inc., Standard & Poor's Corporation, and Fitch Ratings.

Volatility Risk

This risk that the price of a bond with an embedded option will decline when expected yield volatility changes is called volatility risk.