Risks Associated with

Investing in Bonds
by Frank J. Fabozzi

PowerPoint Slides by
David S. Krause, Ph.D., Marquette University

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 Chapter 2 - Risks Associated with
Investing in Bonds
• Major learning outcomes:
– Understand the various risks associated with
investing in bonds:
• Interest rate
• Call and prepayment
• Yield curve
• Reinvestment
• Credit
• Liquidity
• Exchange-rate
• Inflation
• Volatility
• Event
• Sovereign
 Key Learning Outcomes
• Explain the various risks associated with investing in bonds (e.g., interest rate risk,
call and prepayment risk, yield curve risk, reinvestment risk, credit risk, liquidity risk,
exchange-rate risk, inflation risk, volatility risk, and event risk).

• Explain why there is an inverse relationship between changes in interest rates and
bond prices.

• Identify the relationships among a bond’s coupon rate, yield required by the market,
and price relative to par value (i.e., discount, premium, or par value).

• Explain how features of a bond (maturity, coupon, and embedded options) affect its
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 how the yield level impacts the interest rate risk of a bond.

• Explain the interest rate risk of a floating-rate security and why its price may differ
from par value.
 Key Learning Outcomes
• Compute the duration of a bond given its price changes when interest rates change.

• Interpret the meaning of the duration of a bond.

• Use duration to approximate the percentage price change of a bond and calculate the
new price if interest rates change.

• Explain yield curve risk and explain why duration does not account for yield curve risk
for a portfolio of bonds.

• Explain key rate duration.

• Identify the factors that affect the reinvestment risk of a security.

• Explain the disadvantages of a callable and prepayable security to an investor.

• Explain why prepayable amortizing securities expose investors to greater

reinvestment risk than nonamortizing securities.

• Describe the types of credit risk: default risk, credit spread risk, and downgrade risk.
 Key Learning Outcomes
• Explain a rating transition matrix.

• Distinguish between investment grade bonds and noninvestment grade bonds.

• Explain what a rating agency does and what is meant by a rating upgrade and a
rating downgrade.

• Explain why liquidity risk is 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 yield volatility, how it 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.

• Describe the components of sovereign risk.

 Interest Rate Risk
• Bond prices and interest rates move in
opposite directions.

• Since the price of a bond fluctuates with

market interest rates, the risk faced by
investors is that the price of a bond will fall if
rates rise.

• This is referred to as interest rate risk – which

is the major risk faced by bondholders.
 Bond Prices and Interest Rates

Bond Price
Longer term bonds are more
sensitive to changes in interest
rates than shorter term bonds.

P Inverse, non-linear shape

r Yield
 Interest Rate Risk
• Key relationships:
– a bond’s coupon rate
– the yield required by the market
– the bond’s price relative to par value (i.e., discount,
premium, or equal to par)

• Because an investor cannot force the issuer to

change the coupon rate or the time to maturity,
it is the price that will change relative to
movements in market interest rates.
 Interest Rate Risk
• Bond valuation basics:
– A bond will trade at a price equal to par when the
coupon rate is equal to the yield required by the
market.

– A bond will trade at a discount (price below par)

when the coupon rate is below the yield required
by the market.

– A bond will trade at a premium (price above par)

when the coupon rate is above the yield required
by the market.

– If market interest rates increase (decrease), the

price of a bond will decrease (increase).
 Features Impacting Interest
Rate Risk
• The features of a bond that affect interest rate
risk:
– Maturity
– Coupon rate
– Embedded options

• A bond’s price sensitivity to changes in

market interest rates depends on these
key features – which are unique to each
bond issue.
 Maturity Impacts
Interest Rate Risk
• Everything else the same, the longer the bond’s
maturity, the greater the bond’s price sensitivity to
changes in market interest rates.

• The reason: the time value of money. More of

the cash flows are farther out into the future
and the present value changes are the greater.

• 30-year bonds have far greater price sensitivity

than 1-year bonds bearing the same coupon
rate and trading at the same yield.
 Bond Price Volatility:
Coupon Rate and Maturity
• Sensitivity of Prices to Changes in Interest Rate
– Zero-coupon bond: all else the same, has a
greater price change than a coupon-bearing
bond (for a given change in interest rates).
– Non-zero coupon bond (the closer to a zero-
coupon bond, the greater the price change, all else
the same)
• For a given maturity: the lower the coupon, the
greater the price change
• For a given coupon: the longer the maturity, the
greater the price change
 Volatility of Bonds
with Different Maturities
• Consider two bonds with 10% annual coupons with
maturities of 5 years and 10 years. The yield is currently
8%
• What are the price responses to a 1% interest rate
change?
Yield 5-year bond 10-year bond
8% $1,079.85 $1,134.20
9% $1,038.90 $1,064.18
% Change -3.79% -6.17%
Greater price
7% $1,123.01 $1,210.71 change
% Change 4.00% 6.75%
Volatility of Bonds with Different
Coupon Rates
• Consider the following two bonds:
– Both have a maturity of 5 years, both have yield of 8%
– First has 6% coupon, other has 10% coupon, compounded
annually.
• What are the price sensitivities of these bonds to a 1% increase
(decrease) in bond yields?
Greater price
change

Yield 6%-Bond 10%-Bond

8% $920.15 $1,079.85
9% $883.31 $1,038.90
% Change -4.00% -3.79%
7% $959.00 $1,123.01
% Change 4.22% 4.00%
Average 4.11% 3.89%
 Embedded Options Impact
Interest Rate Risk
• No hard and fast rule applies. The value of a bond with
embedded options will change depending upon how the value
of the embedded option changes when market interest rates
change.
– Using a callable bond as an example, it is possible that as
interest rates decline, the price of a callable bond may not
increase as much as an option-free bond, everything else the
same.

• Because the issuer might call the issue when interest

rates fall, the market should reduce the price (increase
the yield) of the callable bond relative to the option-free
bond based on the likelihood the bond will be called.
 Example of the Impact of a Call
Option on Interest Rate Risk
• Callable bonds will be exercised by the issuer if the Net
Present Value of redeeming them is positive.
– This conversely reduces the value of the bonds to the
bondholder because they will be called at a price less than the
market price of a similar non-callable bond.

• When market interest rates fall, the value of the option-

free bond increases, but the value of the embedded
call option increases for the issuer.
– This may result in the price of the callable bond increasing but
not by as much as the price change for a comparable option-
free bond.
 Example of the Impact of a Call
Option on Interest Rate Risk
• Similarly, when market interest rates rise,
the value of the option-free bond
decreases, but the value of the embedded
call option also decreases for the issuer.

• This may result in the price of the callable

bond decreasing, but not by as much as
the price change for a comparable option-
free bond.
 Impact of the Yield Level
• Credit risk results in bonds trading at different yields
even if they have the same coupon rate, maturity, and
embedded options.

• How does the level of a bond’s yield impact price

sensitivity for a change in market rates, holding all other
factors the same?
– The higher a bond’s yield, the lower the bond’s price sensitivity,
all else the same.
– Why? A 100 basis point change when yields are 10% is
relatively less than when yields are at 5%.

• This also means that for a given change in market

interest rates, price sensitivity is lower when the level of
interest rates in the market is high, and price sensitivity
is higher when the level of interest rates is low.
 Interest Rate Risk for Floating
Rate Securities
• The change in the price of a fixed-coupon bond when
interest rates change is due to the fact that the bond’s
coupon rate is different from the prevailing market
interest rate.

• For floating rate bonds, the coupon rate is reset

periodically based on market interest rates (reference
rates plus a quoted margin).
– Note: the quoted margin is set for the life of the bond in the
indenture. Therefore, the price of a floating-rate bond depends
on:
• The length of time between the coupon resetting dates
• The investors’ required margin
• Whether the bond has a cap rate
 Interest Rate Risk for Floating
Rate Securities (continued)
• The length of time between the coupon
resetting dates will impact the amount of
interest rate risk
– The shorter the time between the coupon
reset dates, all else the same, the less price
sensitivity the bond will be exposed.
 Interest Rate Risk for Floating
Rate Securities (continued)
• The investors’ required margin may
change.
– If market conditions change such that
investors want a higher (lower) margin, all
else the same, then the bond’s price will
decline (increase). This is more of a function
of the underlying credit risk of the bond.
 Interest Rate Risk for Floating
Rate Securities (continued)
• If the bond has a cap rate, it can act as a ceiling
on the coupon reset formula, resulting in a bond
returning below market yield, all else the same.

– When the coupon is reset at a cap rate below the

market interest rate, the bond’s price will decline.

– In fact, once the cap has been reached, the bond’s

price will react much the same way to changes in
market interest rates as that of a fixed-rate coupon
bond. This is called cap risk.
 Measuring Interest Rate Risk
• Investors want to know how price sensitive a
bond is to changes in market interest rates.
There is a way to quantify the amount of
interest rate risk.

• The methodology used here is only

approximate, a later chapter will refine the
computation of measuring price sensitivity to
changing interest rates.

• This is the concept know as duration.

 Duration – Used to Measure
Interest Rate Risk
• The formula for estimating the approximate
percentage price change for a 100 basis point
change in yield is:
 Measuring Interest Rate Risk:
Approximate Percentage Price Change
The easiest way to compute the percentage price change of a bond is to
average the percentage price changes resulting from an increase and a
decrease in interest rates of the same number of basis points.

Typically, a 100 basis point change in bond prices is computed to measure

the percentage change in value.

The basic time value of money bond valuation model is used.

After the + and – 100 basis point change in bond prices is computed, it is
necessary to compute the percentage change and average the two
computations.

The formula for approximating the percentage change for a 100 basis point
change in yield is:

[Price (100 bps decline) – Price (100 bps increase)] / [2 X Initial Price X Change in Yield]
 Measuring Interest Rate Risk:
Approximate Percentage Price Change
• The formula for approximating the percentage change
for a 100 basis point change in yield is:
– [Price (100 bps decline) – Price (100 bps increase)] / [2 X
Initial Price X Change in Yield]

• The example in the text resulted in an average of

10.44 basis points change for a 100 basis point
change in market yield.

• This is 10.44 which is the duration of the bond. This

means that for a +/- 1% change in market rates, this
bond would change in price by -/+ .1044%.
– A 50 basis point change would be .1044%/2 or .0522%
 Measuring Interest Rate Risk:
Approximate Percentage Price Change
• Currently, it is necessary to be able to compute and
interpret the duration of a bond, given the bond’s change
in price, when interest rates change using the
approximate percentage price change of a bond
approach.

• In a later chapter we will see that the properties of price

volatility are not symmetric and will see how to fine-tune
the use of duration to measure a bond’s sensitivity to
interest rate changes. We’ll also learn how to compute
and interpret a bond’s convexity.

• For now, this method is a reasonable approximation and

a good way to estimate the amount of interest rate risk
for a bond.
 Measuring Interest Rate Risk:
Approximate Dollar Price Change

• It is possible to take the computation from

the percentage method and approximate
the impact in the price change of the
bond.

• This method is know as dollar duration.

 Yield Curve Risk
• Another key factor that affects the price sensitivity of a bond
(or a portfolio of bonds) is the change in market interest
rates relative to the bonds’ maturity.

• If there were only one interest rate or yield in an economy

the task of estimating the impact of changing yield on a
bond portfolio would be easy, but there are numerous rates
– often based on differing maturity structures.

• The important relationship to understand is between yield

and maturity and it is displaced graphically as the yield
curve.
– Future chapters in the text continue the discussion of the yield curve
and yield spreads.
 Measuring Price Sensitivity to
Interest Rate Changes
• The Effects of Yield to Maturity
– Sometimes credit considerations cause
different bonds to trade at different yields
even if they have the same coupon and
maturity
– Price volatility is lower when yield levels in the
market are high, and price volatility is higher
when yield levels are low
 Example of Measuring Price
Sensitivity to Yield Change
Percentage Price Change for four hypothetical Bonds
Initial yield for all bonds is 6%.

Percent Price Change

New Yield 6% 5 year 6% 20 year 9% 5 year 9% 20 year
4.00 8.98 27.36 8.57 25.04
5.00 4.38 12.55 4.17 11.53
5.50 2.16 6.02 2.06 5.54
5.90 0.43 1.17 0.41 1.07
5.99 0.04 0.12 0.04 0.11
6.01 -0.04 -0.12 -0.04 -0.11
6.10 -0.43 -1.15 -0.41 -1.06
6.50 -2.11 -5.55 -2.01 -5.13
7.00 -4.16 -10.68 -3.97 -9.89
8.00 -8.11 -19.79 -7.75 -18.4

Greatest change for lower coupon,

longer maturity, lower yield
 Yield Curve Risk
• Exhibits 1 and 2 in the text show a four bond portfolio to
highlight the impact of the changes in value relative to a
25 basis point shift. Three examples are provided:
A. Parallel shift in the yield curve
B. and C. Nonparallel shifts in the yield curve

• The example highlights yield curve risk, which exposes

the risk caused by different changes in interest rates for
differing maturities

• Duration can be used on a portfolio of fixed income

securities to understand the approximate change in a
portfolio’s value for a 100 basis point change in the yield
for all maturities.
 Yield Curve Risk
• The yield curve is actually a series of yields,
one for each maturity.

• Therefore to determine the impact of interest

rate risk on a portfolio of bonds with differing
maturities, a rate duration is computed to
measure the impact of a rate change in at
particular maturity (i.e. 5-year rate).
– This is covered in more detail in a later chapter.
Yield Curve Risk – Parallel Shift
Yield Curve Risk – Nonparallel Shift
 Call and Reinvestment Risk
• There are three disadvantages to call provisions
from an investor’s perspective:
1. The cash flow pattern of a callable bond is not known
with certainty because it is not known when the bond
will be called.
2. Because the issuer is likely to call the bonds when
interest rates have declined below the bond’s coupon
rate, the investor is exposed to reinvestment risk.
– This is the risk resulting from the fact that interest earned from an
investment may not be able to be reinvested in such a way that
they earn the same rate of return as the invested funds that
generated them. For example, falling interest rates may prevent
bond coupon payments from earning the same rate of return as
the original bond.
3. The price appreciation potential of the bond will be
reduced relative to a comparable option-free bond.
 Prepayment Risk for Mortgage-
and Asset-Backed Bonds
• The same disadvantages apply to
mortgage- and asset-backed bonds
where the borrower can prepay
principal prior to scheduled principal
payment dates.

• This is referred to as prepayment risk.

 Credit Risk
There are three types of credit risk:
1. Default risk
2. Credit spread risk
3. Downgrade risk

It is important that you be able to evaluate

credit risk. Your major project this
semester will involve the determination of
the level of credit risk of a particular
company’s bond.
 Credit Risk: Default Risk
• Default risk is the risk that the issuer will fail to satisfy
the terms of the bond obligation with respect to the
timely payment of principal and interest.

• The percentage of a population of bonds that is

expected to default is called the default rate.

• A default does not mean the investor loses the entire

amount invested, a percentage of the investment
may be recovered. This is referred to as the
recovery rate.
 Credit Risk: Credit Spread Risk
Even if a bond issue does not go into default, there is the risk
that the market value of the bond will fall because the
return demanded by the market has increased.

Recall that as the required yield increases, the price of a

bond falls. So even if interest rate do not change, it is
possible for a bond to fall in value if the level of credit risk
spread increases.

The yield on a bond is made up of two components:

The yield on a similar default (risk-free) bond
A premium above the yield on a default-free bond to compensate for
the additional risk of the bond. This is the risk premium.

The risk premium is also referred to as the yield spread.

 Credit Risk: Credit Spread Risk
(continued)
• In the U.S. the Treasury security with the same maturity as the
risky bond being evaluated is considered to be risk-free.
– The risk premium or yield spread of a similar maturity bond is the
difference between the yield of the bond and the comparable U.S.
Treasury security.

• The risk that the price an issuer’s bonds will decline due to an
increase in the credit spread is called the credit spread risk.
– This risk is unique for individual companies, as well as for entire
industries and sectors. That is why bond analysts will focus on
understanding the unique risks of individual sectors (i.e. utilities, autos,
financial services, etc.)

• The credit spread trends to increase during recessions and

decrease during economic expansions.
 Credit Risk: Downgrade Risk
• Downgrades result when rating agencies lower their
rating on a bond — for example, a change by
Standard & Poor’s from a B to a CCC rating.

• Downgrades are usually accompanied by bond price

declines. In some cases, the market anticipates
downgrades by bidding down prices prior to the actual
rating agency announcement.

• Before bonds are downgraded, agencies often place

them on a “credit watch” status, which also tends to
cause price declines.
 Credit Risk: Downgrade Risk
• Bond Ratings: The bond's credit rating is the first
indication of the bond's quality.

• Third-party ratings such as Standard and Poor's

(S&P), Moody's, and Fitch assign ratings to bonds,
which reflect their evaluation of the creditworthiness of
an issuer.

• Investment grade bonds are less likely to have their

ratings downgraded or to default than non-investment
grade bonds.

• While investment grade bonds may also be

downgraded or default, a bond with a higher rating is
less likely to experience a downgrade or default.
 Credit Risk: Downgrade Risk
• The quality of any bond is based on the issuer's financial
ability to make interest payments and repay the loan in
full at maturity.
• Rating services help to evaluate the creditworthiness of
bonds. Some bonds, such as municipal bonds, may be
insured by third parties.
Credit Risk: Downgrade Risk
 Credit Risk: Bond Ratings
• The bond market can be divided into two
sectors: the investment grade and non-
investment grade markets as summarized
below:
 Credit Risk: Bond Ratings
• A popular tool used by managers to gauge the prospects of an issue
being downgraded or upgraded is a rating transition matrix. This is
simply a table constructed by the rating agencies that shows the
percentage of issues that were downgraded or upgraded in a given
time period.

• The table can be used to approximate downgrade risk and default

risk.
 Liquidity Risk
• Liquidity risk is the risk that the investor will
have to sell the bond below its indicated value,
where the indication is revealed by a recent
transaction.

• The primary measure of liquidity is the size of

the spread between the bid price (what the
dealer is willing to pay) and the ask price
(what the dealer is willing to sell).

• A liquid market is generally defined by a small

bid-ask spread which does increase materially
for large transactions.
 Liquidity Risk

• Bid-ask spreads are computed by

looking at the best bid and lowest ask.

• This liquidity measure is called the

market bid-ask spread.

• Exhibit 5 shows bid-ask spreads for a

single security.
Liquidity Risk
 Liquidity Risk
• Marking Positions to Market:
– Liquidity risk is not a great concern for non-
institutional investors who will be holding the
position to maturity.

– However, even if an institutional investor

intends to hold the security until maturity,
they are likely required to periodically mark
the position to the market. With a bond that
has low liquidity, the highest bid might be a
low price take would result weak reported
performance.
 Liquidity Risk
• Changes in Market Liquidity:
– Bid-ask spreads change over time, which
result in changes in liquidity risk.

– Because new offerings and products are

being created, the supply and demand
dynamics can cause bid-ask spreads to
change. For instance, the exit or entry of a
major investor can decrease or increase the
relative amount of liquidity for an issue.
 Inflation Risk
• Inflation or
purchasing
power risk arises
from the decline
in the value of a
bond’s cash
flows due to
inflation.
• Inflation volatility
is a closely
watched
measure.
 Volatility Risk
• Volatility risk is the risk that the price of a bond
with an embedded option will decrease when
expected yield volatility changes.

• Basic option valuation concept: The price of an

option increases with more volatility of the
underlying asset, all things equal.

• Therefore, changing yield volatility affects the

price of a bond with an embedded option
– The greater the expected yield volatility, the greater
the value (price) of an option.
 Volatility Risk
• The price of a callable bond is equal to the price of an
option-free bond minus the price of an embedded call
option.
– If expected yield volatility increases, all else the same, the
price of an embedded call option will increase – resulting in a
decrease in the price of a callable bond.

• The price of a putable bond is equal to the price of an

option-free bond plus the price of an embedded put
option.
– If expected yield volatility decreases, all else the same, the
price of an embedded put option will decrease – resulting in a
decrease in the price of a putable bond.
 Volatility Risk
• The risk that the price of a bond with an embedded
option will decline when expected yield volatility
changes is called volatility risk.

• Below is a summary of the effect of changes in expected

yield volatility on the price of callable and putable bonds:
 Event Risk
• Occasionally an issuer is unable to make
either interest or principal payments because
of unexpected events, such as
– A natural catastrophe or disaster, such as a
hurricane or industrial accident
– A corporate takeover or restructuring that prevents
the issuer from making timely payment
– A regulatory change that delays or prevents an
issuer from being able to make payment
• EPA or ERISA regulatory changes
• New rules for financial services, utilities, or insurance
companies could impact the ability to make payment
 Sovereign Risk
• Sovereign risk is the risk that, as the result of
the actions of a foreign government, there
may be either a default or an adverse price
change even in the absence of a default

– Currency revaluations, political change, or war can

result in a change in credit risk

• Sovereign risk has two components:

– Unwillingness of a foreign government to pay

principal or interest
– The inability of a foreign government to pay