Instructor - Sandesh Banger

INSTRUCTOR – SANDESH BANGER
RISKS ASSOCIATED WITH BONDS

Credit risk Interest rate risk
Event Risk Inflation risk
Sovereign Risk Call risk
Liquidity risk Prepayment risk
Exchange-rate risk Reinvestment risk
Volatility risk
Yield curve risk
Instructor - Sandesh Banger

CREDIT RISK
▪Credit risk is the risk that the creditworthiness of a fixed-income security's issuer will
deteriorate, increasing the required return and decreasing the security's value.
▪Measured by Credit Ratings of Bonds (let’s have a look)
▪Lower rated bonds have to offer extra yields, called as Credit Spread
Yield on a risky bond = Treasury Yield + Credit Spread
▪Credit spread risk
 default risk premium or credit spread required in the market for a given rating can increase
 This increases the required yield and decreases the price of a bond
▪Downgrade risk
 Downgrading bond's rating will result in increase in the yield required by investors
 leading to decrease in the price of the bond

EVENT RISK
▪Event risk encompasses the risks outside the risks of financial markets, such as the risks
posed by natural disasters and corporate takeovers.

SOVEREIGN RISK
▪Sovereign risk is essentially the credit risk of a sovereign bond issued by a country
other than the investor's home country.
▪Let’s have a look at India’s Sovereign Credit Rating

LIQUIDITY RISK
▪Liquidity risk has to do with the risk that the sale of a fixed-income security must be
made at a price less than fair market value because of a lack of liquidity for a
particular issue.
▪Treasury bonds have excellent liquidity, so selling a few million dollars worth at the
prevailing market price can be easily and quickly accomplished.
▪At the other end of the liquidity spectrum, a valuable painting, collectible antique
automobile, or unique and expensive home may be quite difficult to sell quickly at
fair-market value.
▪Since investors prefer more liquidity to less, a decrease in a security's liquidity will
decrease its price, as the required yield will be higher.

EXCHANGE-RATE RISK
▪Exchange-rate risk arises from the uncertainty about the value of foreign currency
cash flows to an investor in terms of his home-country currency
▪While a U.S. Treasury bill (T-bill) may be considered quite low risk or even risk-free
to a U.S.-based investor, the value of the T-bill to a European investor will be reduced
by a depreciation of the U.S. dollar's value relative to the euro

INTEREST RATE RISK
▪Interest rate risk refers to the effect of changes in the prevailing market rate of
interest on bond values
▪When interest rates rise, bond values fall. This is the source of interest rate risk which
is approximated by a measure called duration

INFLATION RISK
▪Better described as unexpected inflation risk and even more descriptively as
purchasing-power risk
▪While a $10,000 zero-coupon Treasury bond can provide a payment of $10,000 in

the future with near certainty, there is uncertainty about the amount of goods and
services that $10,000 will buy at the future date
▪This uncertainty about the amount of goods and services that a security's cash flows
will purchase is referred to here as inflation risk

CALL RISK
▪Call risk arises from the fact that when interest rates fall, a callable bond investor's
principal may be returned and must be reinvested at the new lower rates.
▪Bonds that are not callable have no call risk, and call protection reduces call risk.
▪When interest rates are more volatile, callable bonds have relatively more call risk
because of an increased probability of yields falling to a level where the bonds will
be called.

PREPAYMENT RISK
▪Prepayment risk is similar to call risk
▪Prepayments are principal repayments in excess of those required on amortizing

loans, such as residential mortgages.
▪If rates fall, causing prepayments to increase, an investor must reinvest these
prepayments at the new lower rate. Just as with call risk, an increase in interest rate
volatility increases prepayment risk.

REINVESTMENT RISK
▪When market rates fall
 cash flows (interest & principal) must be reinvested at lower rates
 reducing returns of an investor
▪Reinvestment risk is related to call risk and prepayment risk

 In both reinvestment of cash flows at lower rates than expected negatively impacts the investor.
▪Coupon bonds that contain neither call nor prepayment provisions will also be subject
to reinvestment risk, because the coupon interest payments must be reinvested as they
are received
VOLATILITY RISK
▪Volatility risk is present for fixed-income securities that have embedded options, such
as call options, prepayment options, or put options.
▪Changes in interest rate volatility affect the value of these options and, thus, affect
the values of securities with embedded options.

YIELD CURVE RISK
▪Yield curve risk arises from the possibility of changes in the shape of the yield curve
(which shows the relation between bond yields and maturity)
▪While duration is a useful measure of interest rate risk for equal changes in yield at
every maturity (parallel changes in the yield curve), changes in the shape of the yield
curve mean that yields change by different amounts for bonds with different
maturities.

INTEREST RATE RISK – IN DETAIL
▪Market Yield vs. Bond Value
 Plot Market yield vs Bond Prices
 How to do that?
▪Test the following:

 Bond Maturity vs Interest Rate Risk
 Coupon Rate vs Interest Rate Risk
 Yields vs Interest Rate Risk
 Interest Rate Risk of a Zero Coupon Bond
 Interest Rate Risk of a Floater (Floating Rate Bond)

INTEREST RATE RISK OF FLOATING-RATE BOND
▪Coupon rate is periodically reset based on a market-determined reference rate
▪This brings coupon rate in line with current market yield – thus bond sells at/near par
▪Thus floating-rate bonds have low interest rate risk
▪However, between coupon dates,
 there is a time lag between any change in market yield and a change in the coupon rate (which
happens on the next reset date)
 Longer the time period between the two dates, the greater the amount of potential bond price
fluctuation.
 Thus longer (shorter) the reset period, the greater (less) the interest rate risk of a floating-rate security
between two reset dates

INTEREST RATE RISK
Situations Interest Rate Risk
Two bonds are identical except for maturity, Higher/Lower
the one with longer maturity has the greater or lower interest rate risk?
Two otherwise identical bonds, Higher/Lower

the one with higher coupon rate has the higher or lower interest rate risk?
A zero coupon bond will have higher/lower interest rate risk compared to a coupon Higher/Lower
paying bond?

the one offering higher yields will carry higher or lower interest rate risk?

the one with Call option will carry higher or lower interest rate risk?

the one with Put option will carry higher or lower interest rate risk?
MEASURING INTEREST RATE RISK - DURATION
▪Interest rate risk is measured using DURATION
▪Duration refers to sensitivity of a bond’s price to changes in market interest rates or
yields
▪Duration gives us a good approximation of a bond's change in price for a given
change in yield

DURATION
Maturity Increases Duration Increases

Coupon Increases Duration Decreases
Bond Yield Increases (higher yield bond vs lower Duration Decreases
yield bond)
Include Call Option Duration Decreases
Include Put Option Duration Decreases

INTEREST RATE RISKS – EMBEDDED OPTIONS
▪A call feature limits the upside price movement of a bond when interest rates decline;
loosely speaking, the bond price will not rise above the call price. This leads to the
conclusion that the value of a callable bond will be less sensitive to interest rate
changes than an otherwise identical option-free bond.
▪A put feature limits the downside price movement of a bond when interest rates rise;
loosely speaking, the bond price will not fall below the put price. This leads to the
conclusion that the value of a putable bond will be less sensitive to interest rate
changes than an otherwise identical option-free bond.

DURATION
▪Interest rate risk is measured using DURATION
 Duration refers to sensitivity of a bond’s price to changes in market interest rates or yields
▪Duration gives us a good approximation of sensitivity and is often not an accurate

measure (we will see why)
▪Types of Duration Measure:

 Macaulay Duration
 Modified Duration
 Effective Duration

MACAULAY DURATION
▪Weighted average time to maturity of a Bond – thus called Duration
▪Each time period is weighted by % of present value of cash flows received during
that year
▪Gives an estimate of number of years by which invested amount will be returned

▪Frequently used by portfolio managers who use an immunization strategy

MODIFIED DURATION
▪Approximate Percentage change in bond price for a 1% change in interest rate
▪Two ways of calculating Modified Duration – answer may be slightly different using
the two methods
▪1) From Macaulay Duration →
▪2) Modified Duration = - (% change in bond price) / interest rate change

MODIFIED DURATION
Modified Duration = - (% change in bond price) / interest rate change

MODIFIED DURATION

MODIFIED DURATION

MODIFIED DURATION

MODIFIED DURATION

MODIFIED DURATION

EFFECTIVE DURATION

CONVEXITY
▪Above is formula for effective convexity (approximate value)

▪There are other methods of calculating convexity – most correct is 2nd order derivative of
Price
CONVEXITY
▪FV $1000, 8% Semi-annual Coupon
▪20 year Maturity, Bond Price $908
▪YTM 9%
▪Calculate
 Effective Duration
 Effective Convexity
 New Bond Prices for 1% increase & 1%
decrease in yield

DURATION + CONVEXITY



PRICE VALUE OF BASIS POINT

PRICE VALUE OF BASIS POINT

YIELD CURVE RISK
▪Yield curve risk arises from the possibility of
changes in the shape of the yield curve (which
shows the relation between bond yields and
maturity)
▪While duration is a useful measure of interest

rate risk for equal changes in yield at every
maturity (parallel changes in the yield curve),
changes in the shape of the yield curve mean
that yields change by different amounts for
bonds with different maturities.

YIELD CURVE RISK
▪Impacts Bond Portfolios
▪For a non-parallel shift in the yield curve, the

yields on different bonds in a portfolio can
change by different amounts, and duration
alone cannot capture the effect of a yield
change on the value of the portfolio. This risk
of decreases in portfolio value from changes
in the shape of the yield curve (i.e., from non-
parallel shifts in the yield curve) is termed
yield curve risk

YIELD CURVE RISK & DURATION OF BOND PORTFOLIO
▪Yield Curve Risk impacts Bond Portfolios. Let’s see how?


▪How much will the portfolio lose if yield increases by 1% pa?
Duration, thus, is a good measure of interest rate risk only for parallel changes in yield curve

LIQUIDITY RISK
▪Investors will require a higher yield for less liquid securities
▪The difference between the price that dealers are willing to pay for a security (the
bid) and the price at which dealers are willing to sell a security (the ask) is called the
bid-ask spread. The bid-ask spread is an indication of the liquidity of the market for
a security. If trading activity in a particular security declines, the bid-ask spread will
widen (increase), and the issue is considered to be less liquid

VOLATILITY RISK
▪Volatility risk is present for fixed-income securities that have embedded options, such
as call options, prepayment options, or put options.
▪Changes in interest rate volatility affect the value of these options and, thus, affect
the values of securities with embedded options.

PRICE OF A CALLABLE BOND
▪A call option favors the issuer and decreases the value of a callable bond relative to
an otherwise identical option-free bond.
▪The issuer owns the call. Essentially, when you purchase a callable bond, you have
purchased an option-free bond but have given a call option to the issuer.
▪The value of the callable bond is less than the value of an option-free bond by an
amount equal to the value of the call option. Thus
Callable bond value = Value of option-free bond - Value of embedded call option
▪An increase in yield volatility increases the value of the call option and decreases the
market value of a callable bond

PRICE OF A PUTTABLE BOND
▪A put option favors the investor and increases the value of a bond relative to an
otherwise identical option-free bond.
▪The investor owns the put. Essentially, when you purchase a puttable bond, you have
purchased an option-free bond and also purchased a put option.
▪The value of the puttable bond thus equals value of an option-free bond plus value
of the call option
Puttable bond value = Value of option-free bond + Value of put option
▪An increase in yield volatility increases the value of the put option and increases the
market value of a puttable bond

VOLATILITY RISK
▪Thus increase in interest rate volatility affect the prices of callable bonds and
puttable bonds in opposite ways
▪Volatility risk for callable bonds is the risk that volatility will increase, and volatility
risk for puttable bonds is the risk that volatility will decrease.

Instructor - Sandesh Banger

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Instructor - Sandesh Banger

Uploaded by

Copyright:

Available Formats

INSTRUCTOR – SANDESH BANGER

RISKS ASSOCIATED WITH BONDS