CFA Level I

Study Session 15 Reading 52

Reading 53
Reading 54
Reading 55
Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
 CFA Level I: Fixed Income
LOS 53:
Risk associated with investing in Bonds
• explain the risks associated with investing in bonds,
• identify the relations among a bond's coupon rate, the yield required by the
market, and the bond's price relative to par value
• explain how features of a bond and the level of a bond’s yield affect the bonds
interest rate risk
• identify the relationship among the price of a callable bond, the price of an option-
free bond, and the price of the embedded call option
• explain the interest rate risk of a floating-rate security and why such a security's
price may differ from par value
• calculate and interpret the duration and dollar duration of a bond
• describe yield-curve risk and explain why duration does not account for yield-curve
risk for a portfolio of bonds
• explain the disadvantages of a callable or prepayable security to an investor
 CFA Level I: Fixed Income
LOS 53:
Risk associated with investing in Bonds
• identity the factors that affect the reinvestment risk of a security and explain why
pre-payable amortizing securities expose investors to greater reinvestment risk than
non-amortizing securities;
• describe the various forms of credit risk and describe the meaning and role of credit
ratings
• explain liquidity risk and why it might be important to investors even if they expect
to hold a security to the maturity date
• describe the exchange rate risk an investor faces when a bond makes payments in a
foreign currency
• explain inflation risk
• explain how yield volatility affects the price of a bond with an embedded option
and how changes in volatility affect the value of a callable bond and a putable bond
• describe the various forms of event risk and the origins of sovereign risk.
Types of Bond Risks
Risk associated with Bonds are:

1. Interest Rate Risk

2. Call And Prepayment Risk
3. Yield Curve Risk
4. Reinvestment Risk
5. Credit Risk
6. Liquidity Risk
7. Exchange-rate Risk
8. Volatility Risk
9. Inflation Or Purchasing Power Risk
10. Event Risk
11. Sovereign Risk

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Relationship between bond’s coupon
rate, yield and price

Coupon rate = market yield → bond will trade at par

Coupon rate < market yield → bond will trade at discount

Coupon rate > market yield → bond will trade at premium

Bond value

Premium
to par
Par Value
Discount to par

7% 8% 9% 10% 11% Market yield

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Affect of bond features on interest
rate risk
Interest rate risk is the sensitivity of bond’s value with respect to changes in market interest rates.

Maturity
Longer maturity → greater interest rate risk

Coupon rate
Lower coupon rate → greater interest rate risk

Embedded options
Price of a callable bond = price of option free bond – price of embedded call option
Put option → lower interest rate risk

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Floating rate security
Floating rate security has a lower interest rate risk because the coupon rate on this security resets itself according to
changes in market interest rates.

Price of a this security depends on three factors:

1. Time between coupon reset dates:
longer time → higher interest rate risk

2. Changes in the margin required by the investors

as reset date approaches → lower interest rate risk

3. Presence of a cap increases interest rate risk

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Duration

% change in price for a 100 basis point change in the yield.

price when yield decreases — price when yield increase

Duration =
2 * initial price * decimal change in yield

Example: if market yield goes up by 0.25%, bond price goes from 990 to 980. when market yield goes
down by 0.25%, bond price increase to 1010.

1010-980
Duration = = 6.06
2 * 990 * 0.0025

Dollar price change for a 100 basis points is referred to as Dollar duration.

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Yield curve risk
Graphical relationship of a bond’s maturity and yield is called yield curve.

Yield curve can be upward sloping, downward sloping or a flat curve.

When yield on all the bonds in the portfolio change by same amount then yield curve faces a parallel shift.
When yield on all the bonds in the portfolio change by different amounts then yield curve faces a non parallel shift
and this concept is not captured by duration.
Yield
Non-parallel shift
parallel shift
Initial yield curve

Yield Curve

Maturity

Key rate duration is used for unparalleled shifts of yield curve.

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Call and prepayment risk
Disadvantages:

1. Uncertain cash flow pattern

2. Decreasing interest rates may increase the chance of calling provisions and prepayment options

3. Price appreciation will be less than option free bond(price compression)

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Reinvestment risk
Reinvestment risk is when the proceeds received from the payment of principal and interest can be
reinvested at a lower interest rate. Bond investor generally faces this risk when he purchases a callable or
pre-payable bond.

In case of amortising securities, reinvestment risk is higher.

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Credit risk

An investor who lends the fund by purchasing bonds is exposed to credit risk.

Three types of credit risk:

1. Default risk – unable to meet the obligation
2. Credit spread risk – decline in value of bond
3. Downgrade risk – lower rating → gives an indication of default risk

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Liquidity risk
 Bid – ask spread is the indicator of liquidity risk.

 Higher the spread, greater the risk.

 It is the risk that investor will have to sell its security at a lower price.

 An investor who plans to hold the security till maturity, increasing liquidity risk will lead to low prices
and eventually lower returns.

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Exchange rate risk

Risk of receiving less cash flows because of investing in a bond that makes payments in foreign currency.

This happens due to depreciation of domestic currency.

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Inflation risk
Inflation risk is the risk of increase in price of goods and services, also known as purchasing power risk.

Increase in inflation reduces the real amount of goods and services that can be purchased from the same
amount.

Eg: if the coupon rate is 7% and inflation is 4%, the purchasing power has increased by only 3% and not by
7%.

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Volatility risk

Greater the volatility, greater is the value of the option.

Price of a callable bond = price of option free bond – price of embedded call option
↑ expected yield volatility → ↑ price of call option → ↓ price of callable bond

Price of a putable bond = price of option free bond + price of embedded put option
↓ expected yield volatility → ↓ price of put option → ↓ price of putable bond

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Event risk
Following factors unexpectedly changes the ability of an issuer to make interest and principal payments:

1. Natural disasters
2. Corporate restructurings
3. Regulatory issues

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Sovereign risk

Investors who buy foreign government’s bond face sovereign risk.

1. Credit spread on sovereign bond might increase

2. Its credit rating might decline
3. Government can repudiate its own debt
4. Government may default due economic conditions

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