Risks Associated with Investing in Bonds

Reading 54. Risks Associated with Investing in Bonds

Key Concepts

1. There are many types of risk associated with fixed income securities:
   • Interest rate risk is defined as the sensitivity of bond prices to changes in interest rates.
   • Call risk is the risk that a bond will be called (redeemed) prior to maturity under the terms of the call provision and that the funds must then be reinvested at the current (lower) yield.
   • Prepayment risk is the risk that the principal on amortizing securities will be repaid early and then must be reinvested at a lower (current) market yield.
   • Yield curve risk is the risk that changes in the shape of the yield curve will negatively impact bond values.
   • Credit risk includes both the risk of default and the risk of decreases in bond value due to a downgrade (reduction in the bond's credit rating).
   • Liquidity risk is the risk that an immediate sale will result in a price below fair value (the prevailing market price).
   • Exchange rate risk is the risk that the foreign exchange value of the currency that a foreign bond is denominated in will fall relative to the home currency of the investor.
   • Volatility risk is the risk that changes in interest rate volatility will affect the value of bonds with embedded options. More volatility decreases callable bond values and increases putable bond values.
   • Inflation risk is the risk that inflation will be higher than expected, eroding the purchasing power of the cash flows from a fixed income security.
   • Event risk is the risk of decreases in a security's value from disasters, corporate restructurings, or regulatory changes that negatively impact the firm.
   • Sovereign risk is the risk that governments may repudiate debt, prohibit debt repayment by private borrowers, or impose general restrictions on currency flows.
2. When a bond's yield is above(below) its coupon rate, it will trade at a discount(premium) to its par value.
3. The interest rate risk of a bond is positively related to its maturity, negatively related to the coupon rate, and is less for bonds with an embedded option (either puts or calls).
4. The price of a callable bond equals the price of an identical option-free bond minus the value of embedded call.
5. The higher the market yield, the lower the interest rate risk.
6. Floating-rate bonds have interest rate risk between reset dates and may also differ from par value due to changes in liquidity or in credit risk after they have been issued.
7. The duration of a bond is the approximate percentage price change for a 1% change in yield.
8. The percentage price change in a bond = – duration * yield change in percent.
9. When yield curve shifts are not parallel, the duration of a bond portfolio does not capture the true price effects because yields on the various bonds in the portfolio may change by different amounts.
10. A security has more reinvestment risk when it has a higher coupon, is callable, is an amortizing security, or has a prepayment option.
11. A prepayable amortizing security has greater reinvestment risk because of the probability of accelerated principal payments when interest rates (including reinvestment rates) fall.
12. Credit risk includes default risk (the probability of default), downgrade risk (the probability of a reduction in the bond rating), and credit spread risk (uncertainty about the bond's yield spread to Treasuries based on its bond
    rating).
13. Lack of liquidity can negatively impact periodic portfolio valuation and performance measures for a portfolio and thus can affect a manager even though sale of the bonds is not anticipated.
14. An investor who buys a bond with cash flows denominated in a foreign currency will see the value of the bond decrease if the exchange value of the foreign currency declines (the currency depreciates).
15. If inflation increases unexpectedly, the purchasing power of the cash flows is decreased and bond values fall.
16. Increases in yield volatility increase the value of put and call options embedded in bonds, decreasing the value of a callable bond (because the bondholder is short the call) and increasing the value of putable bonds.
17. Event risk encompasses events that can negatively affect the value of a security, including disasters that negatively impact earnings or diminish asset values, takeovers or restructurings that can negatively impact bondholder claims, and changes in regulation that can negatively affect earnings.