Chapter 3

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.

 The Various Risks Associated with
Investing in Bonds
• Interest rate risk
• Call and prepayment risk
• Yield curve risk
• Reinvestment risk
• Credit risk
• Liquidity risk
• Exchange-rate risk
• Inflation risk
• Volatility risk
• Event risk
• Sovereign risk
 Bond Pricing &Interest Rate Risk
• Bond prices and interest rates move in opposite
directions.
N
P   (1Ck )t  F
(1 k ) N
t 1

• Since the price of a bond (P) fluctuates with market

interest rates (k), 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 Pricing &Interest Rate Risk
• Bond prices and interest rates move in opposite
directions.
N
P   (1Ck )t  F
(1 k ) N
t 1

• EX: What is the price of a 10-year, 10% straight

corporate bond at an interest rate of 10%? 13% or 7%

• The cash flows for a simple bond are the coupon or

interest payments ($1,000*10%) and the principal
value ($1,000).
 Interest Rate Risk
• At 10% interest rate:
$100 $100 $1,000
VB   ...  
(1.10)1 (1.10)10 (1.10)10
VB  $90.91  ...  $38.55  $385.54
VB  $1,000

• At 13% interest rate:

$100 $100 $1,000
VB   ...  
(1.13)1 (1.13)10 (1.13)10
VB  $88.50  ...  $25.61  $256.07
VB  $837.21

• At 7% interest rate:
$100 $100 $1,000
VB   ...  
(1.07)1 (1.07)10 (1.07)10
VB  $93.46  ...  $54.39  $543.93
VB  $1,210.71
 Interest Rate Risk
• If this is a 5-year bond:
• At 10% interest rate:
$100 $100 $1,000
VB  1
 ...  5

(1.10) (1.10) (1.10) 5
VB  $90.91  ...  $62.09  $620.92
VB  $1,000

• At 13% interest rate:

$100 $100 $1,000
VB  1
 ...  5

(1.13) (1.13) (1.13) 5
VB  $88.50  ...  $54.28  $542.76
VB  $894.48

• At 7% interest rate:
$100 $100 $1,000
VB  1
 ...  5

(1.07) (1.07) (1.07) 5
VB  $93.46  ...  $71.30  $712.99
VB  $1,123.01
 Interest Rate Risk
Interest Rate 5-year 10% bond 10-year 10% bond

Price % Change in Price Price % Change in Price

13% $894.48 -10.55% $837.21 -16.28%

10% $1,000 $1,000

7% $1,123.01 +11.23% $1,210.71 +21.07%

Question: What patterns you see on the relationship

between interest rates and Bond prices?
 Interest Rate Risk
• Two relationships between interest rates and
bond prices can be observed:

• 1. Bond prices are inversely related to interest

rates;

• 2. The longer the maturity of a bond, the larger

the percentage price change when interest rate
changes by the same percentage.
– This means the longer the maturity of a bond, the
more sensitive of its price to interest rate changes.
 Interest Rate Risk
• Example: a 6%, 20-year bond is trading at
$100 when the required yield is 6%.
– If the required yield increases to 6.5%, the bond
price declines to $94.4479 for a decrease of 5.55%
in price.
– If the required yield decreases to 5.5%, the bond
price increases to $106.0195 for an increase of
6.0195% in price.

• Question: Why bond price decreases by 5.55% when

the required yield increased by 0.5% and increases
by 6.0195% when the required yield decreased by
0.5%?
 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
 Bond Prices and Interest
Rates
• A bond’s price sensitivity to interest rate
changes is generally measured by its duration:

• Duration = - (ΔP/P)/(Δk/k)

• Duration or the bond price sensitivity is changing

depending on the features stated above, such
as maturity, coupon rate, and embedded options.
 Bond Prices and Interest
Rates
• The approximation formula for estimating the
approximate percentage price change for a 100
basis point change in yield is:
 Features Impacting Interest
Rate Risk
• The features of a bond that affect interest
rate risk:
– Maturity
– Coupon rate
– Embedded options
 How Maturity Affects the Bond’s
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.

• Example 1:
Interest Rate Price of a 6%, 20-yr bond Price of a 6%, 5-yr bond

5.5% $106.0195 (+6.0195%) $102.1351 (+2.1351%)

6% $100.0000 $100.0000

6.5% $94.4479 (-5.5521%) $97.8944 (-2.11%)

• Question: Why the longer the bond’s maturity, the greater

the bond’s price sensitivity? Can you give an intuitive
explanation?
 How Maturity Affects the Bond’s
Interest Rate Risk
• 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.
 How Maturity Affects the Bond’s
Interest Rate Risk
• Another example for exercise:

• 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%
 How Coupon Affects the Bond’s
Interest Rate Risk
• 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 5-yr, 6%-Bond5 yr, 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%
How Coupon Affects the Bond’s
Interest Rate Risk
• Conclusion: Other things the same, bond with a lower
coupon rate will have a larger price change when
interest rate goes up or down by 1%, as compared to the
bond with a higher coupon rate.

• The reason: Again, the same discounting effect. Bonds

with a lower coupon rate will place more weights on the
cash flows to be received in later periods. For a one
percentage interest rate change, this will produce a
bigger impact of the price changes.
 How Embedded Options Affect
the Bond’s Interest Rate Risk
• 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.

• Price of callable bond

• = price of option-free bond
• – price of the embedded call option

• 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.
 How Call Options Affect the
Bond’s 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.
 How Call Options Affect the
Bond’s 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.
 How the Yield Level Affects the
Bond’s Interest Rate Risk
• 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.
– A 100 basis point change when yields are 10% is
relatively less than when yields are at 5%.
– Why?

• 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
• For floating rate bonds, the coupon rate is
reset periodically based on market interest
rates (reference rates plus a quoted margin).
– 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.
 Yield Curve Risk
• 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.
 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 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
• 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
Parallel Shift in Yield Curve of +25 bps
Bond Coupon (%) Maturity Original Yield Par Value ($) New Yield (%) New Bond Value
(%) Price
A 5.00 2 5.00 5,000,000 5.25 (+.25%) 99.5312 4,976,558
B 5.25 5 5.25 10,000,000 5.50 (+.25%) 98.9200 9,891,999
C 5.50 20 5.50 20,000,000 5.75 (+.25%) 97.0514 19,410,274
D 5.75 30 5.75 30,000,000 6.00 (+.25%) 96.5406 28,962,166
Total 65,000,000 63,240,997

Non-Parallel Shift in Yield Curve

Bond Coupon (%) Maturity Original Yield Par Value ($) New Yield (%) New Bond Value
(%) Price

A 5.00 2 5.00 5,000,000 5.10 (+.10%) 99.8121 4,990,066

B 5.25 5 5.25 10,000,000 5.45 (+.20%) 99.1349 9,913,488
C 5.50 20 5.50 20,000,000 5.75 (+.25%) 97.0514 19,410,274
D 5.75 30 5.75 30,000,000 6.20 (+.45%) 93.9042 28,171,257

Total 65,000,000 62,485,625

Non-Parallel Shift in Yield Curve

Bond Coupon (%) Maturity Original Yield Par Value ($) New Yield (%) New Bond Value
(%) Price
A 5.00 2 5.00 5,000,000 5.05 (+.05%) 99.5312 4,995,300
B 5.25 5 5.25 10,000,000 5.40 (+.15%) 98.9200 9,935,033
C 5.50 20 5.50 20,000,000 5.75 (+.25%) 97.0514 19,410,274
D 5.75 30 5.75 30,000,000 6.10 (+.35%) 96.5406 28,562,467
Total 65,000,000 62,903,074
 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).
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
 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: Recovery Rates
• Average corporate debt recovery rates measured by pos-default trading
prices based on 30-day postdefault market price:
Lien Position Issuer Weighted Value Weighted
2008 2007 1982-2008 2008 2007 1982-2008
Bank Loans
Sr. secured 63.4% 68.6% 69.9% 49.0% 78.3% 62.1%
Second lien 40.4% 65.9% 50.4% 36.6% 65.8% 49.8%
Sr. unsecured 29.8% ------- 52.5% 22.6% ------ 41.0%

Bonds
Sr. secured 58.00% 80.5% 52.3% 45.9% 81.7% 53.0%
Sr. Unsecured 33.8% 53.3% 36.4% 26.2% 56.9% 32.4%
Sr. subordinated 23.0% 54.5% 31.7% 10.4% 67.7% 26.4%
Subordinated 23.6% ------ 31.0% 7.3% ------ 23.5%
Jr. subordinated ------ ------ 24.0% ------ ------ 16.8%

Pref. Stock
Trust preference ------ ------ 11.7% ------ ------ 13.0%
Non-Trust preference 8.6% ------ 21.6% 1.7% ------ 13.1%
 Credit Risk: Credit Spread Risk
• 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-free (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.

Bond Yield = Risk-free rate + risk premium (yield spread)

Bond Yield = Treasury yield + risk premium (yield spread)
Yield spread = Bond yield – Treasury yield
 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.

• The credit spread tends to increase during recessions and

decrease during economic expansions.
Credit Spread
 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.
 Volatility Risk
• Volatility risk is the risk that the price of a bond
with an embedded option may 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: