RISKS ASSOCIATED WITH INVESTING IN BONDS 1 Risks Associated with Investing in s Interest Rate Risk Effect of changes in prevailing market interest rate on values. As i B p. Credit Risk Creditworthiness of issuer will deteriorate causing required return to rise & security s value to fall. Country s ability to repay. Important in most defaults & downgrades. Yield Curve Risk Risk arising from the possibility of changes in the shape of yield curve. Liquidity Risk Immediate sale of security may force sale at a price below fair value. Liquidity price required yield. Sovereign Risk Change in govt. s attitudes & policies towards the repayment & servicing of debt. Two Components Call Risk may be called when i & amount will have to be reinvested at a lower rate; cash flow pattern of callable bonds is uncertain; and reduced price appreciation potential Non-Callable No call risk. Call protection Reduced call risk. Higher volatility Higher call risk. Inflation Risk Also known as purchasing power risk. Uncertainty about the purchasing power of security s cash flows. Govt. s willingness to repay. Prepayment Risk Prepayments as i hence prepayments have to be reinvested at new lower rate. Higher volatility Higher Risk Volatility Risk Present for fixedincome securities, with embedded options. Reinvestment Risk As i, cash flows are reinvested at lower rate & hence return. Non-Callable zero Coupon has no proceeds to be reinvested & hence has no reinvestment risk. Event Risk Risks other than that of financial markets. E.g., natural disasters. & corporate takeovers. Relationship between s 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
2 Effects of a bond s features on interest rate risk Maturity Longer maturity Higher duration Higher interest rate risk. Characteristic Coupon rate Higher coupon rate Lower duration Lower interest rate risk. Interest rate risk Maturity Coupon Add call Add put Measure of interest rate risk. Measures price sensitivity of a security to changes in interest rate. 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. Presence of embedded options Conclusion Value of callable & putable bond is less sensitive to interest rate changes. 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. Relationship among option free bond callable bond & option value Disadvantages of a callable / prepayable security Value of callable bond = value of option free bond option value Uncertain cash flow stream. Reinvestment risk rises as interest rate falls. Less potential of price appreciation. As yield falls Value of callable bond rises less relative to the value of option free bond. Difference b/w prices of callable & option-free bond rises. Higher coupon Call feature present. Prepayment option present. Amortizing security. Higher reinvestment Risk & Lower interest rate risk
3 Interest rate risk of floating rate securities Reset Mechanism Coupon rate is periodically reset based on a market determined reference rate. Impact of Reset period Longer (shorter) the reset period greater (less) the interest rate risk at any reset date. 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 less sensitive to changes in market yield. Measure of price sensitivity of a security to changes in yield. = % % for a portfolio of bonds Approximate % age in portfolio s value for a unit (equal) in yields for all bonds. Zero Coupon bond Approximately equal to its years to maturity. Floater Equal to the fraction of a year until the next reset date. of amortizing securities < 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 change by different amount. Yield Curve Risk Risk of decreases in portfolio value from changes in shape of yield curve i.e., nonparallel shifts
4 Credit Rating Indicates relative probability of default. ratings are not an absolute measure of default risk. ratings provide relative probability of default across companies & bonds. Basis of Ratings Financial strength of a company. S & P AAA AA+AA AA- AA+ A AA- BBB+ BBB BBB- BB+ BB BB- B CCC+ CCC CC C Investment grade. Credit Spread Risk Even when the default free rate hasn t changed, default risk premium required in the market for a given rating can increase. Credit spread required Junk speculative or high yield. yield s price. Moody s Aa1 Aa2 Aa3 Default Issuer not making timely interest & principal payments. Difference in the priority of bondholder s claim. Default Risk The risk that payments won t be made as promised or scheduled. Reasons for differences in ratings of s of same Company Credit spread or default risk premium = yield of the subject bond- yield on default free bond. Downgrade Risk Credit rating agency will lower a bond s rating. Difference in collateral Rating Upgrade Credit rating agency will increase a bond s rating. 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 dealer s bid prices. Absence of dealer s bid prices. While periodic reporting the prevailing market price may misstate the true value of the security & can reduce return or performance. Effects of decline in liquidity on institutional investor In case of repo agreement, lower valuation of collateral value can lead to a higher cost of funds and reduced portfolio performance. Bid-Ask spread Difference b/w Bid & Ask price. It is an indication of the liquidity of the security market. As liquidity Bid-Ask spread.
5 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. Event Risk Not related with financial market For callable Volatility will rise. Volatility risk For putable Volatility will fall. Value of callable = value of option free value of call Value of putable = value of option free + value of put Value of Yield volatility Put Call Putable Callable Disasters Corporate Restructurings Regulatory Issues.