Fixed Income - Risks Associated with Investing in Bonds

Reading 54 in CFAI materials

Bonds and fixed income are near and dear to my heart having worked in financial restructuring advisory in a past life.  As such I'll probably only write here things that are new/counterintuitive/special to me.

Lower coupon rate = more sensitive to changes in interest rate

Price of callable bond = price of option free - price of embedded call option

When interest rates rise, both the price of the option free and the price of the call option rise

Typically, callable bond will not increase by as much as noncallable, and will not decrease as much either

Higher bond yield means lower price sensitivity - lower yield bonds are more price sensitive in both percentage and absolute terms (all else equal)

• Price sensitivity generally higher when market interest rates are low
• Price sensitivity generally lower when market interest rates are high

Floaters

1. If there is a long time to next reset, it will be more volatile
2. If the general required margin changes, price will change
3. Cap risk - if there is a cap, it basically behaves like a fixed rate security

Duration = percentage price change for a 100 bp change in yield

Rough formula: (price if yields decline - price if yields rise) / (2* initial price * change in yield)

Duration computation is only as good as the valuation model used to get the up/down prices

Dollar price change - just multiply by face value.  Change in dollars in response to 100 bp change is called dollar duration.

Yield curve risk - portfolios have different exposures to how the yield curve shifts - therefore any measure of interest rate risk that assumes all interest rates change by the same amount for all maturities is only an approximation (referred to as a parallel yield curve shift) 

Duration for a portfolio is an example - it's the same measure as a duration for a single security, but instead represents the change in the value of the portfolio when ALL yields change by the same amount

Rate duration (to be discussed later) - rate refers to interest rate of a particular security - this is a measure for a non-parallel shift in the yield curve where only that particular rate changes (e.g. the 5 year rate duration of 2 means that the portfolio's value would change by about 2% for a 100 bp change in the 5 yr yield)

There is not a single rate duration, but a rate duration for each maturity

Disadvantages of call options (aka Call Risk)

1. Unpredictable cash flows
2. Reinvestment risk - might not find as good a yield
3. Price appreciation not as good as option free bond

Reinvestment risk - yields assume that funds can be reinvested at same rate

Reinvestment risk even greater for amortizing bonds - need to reinvest each month and borrowers can prepay every month, not just every 6 months

Means that zero coupons might be attractive - no reinvestment risk - but greater interest rate risk

Credit risk

1. Default - risk that issuer will not pay timely interest/principal
2. Credit spread - yields increase, price goes down; yield is made up of a risk free component and a premium above which is the yield spread.  Usually benchmarked to treasury.
1. Risk of default component is called the credit spread
2. Can apply to individual issues, industries, or economies
3. Downgrade - unanticipated downgrade will increase the credit spread

Liquidity risk - might have to sell below its indicated value - mainly measured by bid ask spread.  Liquidity risk of an issue changes over time.  New structures are very risky because you don't know how liquid they will end up being.

Exchange rate risk - you are afraid that the currency of the bond you own will get weaker.  Ex, you are a US investor buying a Japanese bond.  If yen gets weak, when you get paid in yen this is bad because you can't buy as many dollars.

Volatility - the greater the volatility, the greater the value of an option

• Price of Callable bond = price of option free - price of embedded call
• Higher volatility decreases price of bond
• Price of Putable bond = price of option free + price of embedded put
• Higher volatility increases price of bond

Event risk

• Natural disaster etc.
• Similar to downgrade risk but downgrade is usually confined to one issuer
• Corporate takeover/restructuring - RJR e.g. changed the environment of debt/LBOs
• Regulatory - might need to dump certain securities

Sovereign - actions by government can increase default risk and/or credit spread - can be from 1) a foreign government's unwillingness to pay and 2) inability to pay.  Most are the latter.

End of reading.