1.

Explain 12 types of risks in fixed income securities and give examples based on real
data (mention the reliable source).
a. Market, or interest-rate, risk
The price of a typical fixed income security moves in the opposite direction of the
change in interest rates: As interest rates rise (fall), the price of a fixed income security
will fall (rise).
For instance For an investor who plans to hold a fixed income security to maturity, the
change in its price before maturity is not of concern; however, for an investor who may
have to sell the fixed income security before the maturity date, an increase in interest
rates will mean the realization of a capital loss.
Example :
When the Federal Reserve increased interest rates in March 2017 by a quarter
percentage point, the bond market fell. The yield on 30-year Treasury bonds dropped
to 3.108% from 3.2%, the yield on 10-year Treasury notes fell to 2.509% from 2.575%,
and the two-year notes' yield fell from 1.401% to 1.312%.
The Fed raised interest rates four times in 2018. After the last raise of the year
announced on December 19, 2018, the yield on 10-year Treasury notes fell from
2.868% to 2.794%.
Source : https://www.investopedia.com/ask/answers/why-interest-rates-have-inverse-
relationship-bond-prices/
b. Reinvestment risk
The variability in the returns from reinvestment from a given strategy due to changes
in market rates is called reinvestment risk. The risk here is that the interest rate at which
interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer
holding periods. It is also greater for securities with large, early cash flows such as
high-coupon bonds.
Example:
an investor buys a 10-year $100,000 Treasury note with an interest rate of 6%. The
investor expects to earn $6,000 per year from the security. However, at the end of the
term, interest rates are 4%. If the investor buys another 10-year $100,000 Treasury
note, he will earn $4,000 annually rather than $6,000. Also, if interest rates
 subsequently increase and he sells the note before its maturity date, he loses part of the
principal.
For example, consider a Angkasa Pura’s bond with a 10% yield to maturity (YTM). In
order for an investor to actually receive the expected yield to maturity, she must
reinvest the coupon payments she receives at a 10% rate. This is not always possible.
If the investor could only reinvest at 4% (say, because market returns fell after the
bonds were issued), the investor's actual return on the bond investment would be lower
than expected.
Source : http://www.pefindo.com/index.php/pageman/page/corporates-ratings-
reports.php?id=393
c. Timing, or call, risk
Callable” means that the issuer can pay off the bond before maturity. One of the primary
reasons bonds are called is because interest rates have fallen since the bond's issuance
and the corporation or the government can now issue new bonds with lower rates, thus
saving the difference between the older higher rate and the new lower rate.
For Example : Remember that issuers usually call bonds when interest rates fall,
leaving the investor to reinvest the proceeds at a lower rate. So if Vanguard Short-Term
Corporate Bond are callable, and rates fall from 10% to 3%, Vanguard Short-Term
Corporate Bond will probably call the 10% bonds and issue new bonds with a lower
coupon. The holders of the 10% bonds would receive their principal back (and probably
a small call premium), but they would then have to find other investments, none of
which would probably pay as well as the Vanguard Short-Term Corporate Bond
Source : https://www.investing.com/etfs/vanguard-short-term-corp-bond
d. Credit risk
The credit risk of a bond includes
1. The risk that the issuer will default on its obligation (default risk).
2. The risk that the bond’s value will decline and/or the bond’s price performance will
be worse than that of other bonds against which the investor is compared because either
(a) the market requires a higher spread due to a perceived increase in the risk that
the issuer will default.
(b) companies that assign ratings to bonds will lower a bond’s rating.
 Example :
Perikanan Nusantara Bond get rating from PEFINDO is BBB-, so the investor can
evaluate the credit risk. For a risk averse investor mau opt to buy a AAA- rated,
meanwhile a risk-seeking investor may buy a bond with a lower rating in exchange
for potentially higher returns. This company has the low rating and have a high
default risk. It is better to invest in the high rating such as AAA, AA, A, in order
to mitigate the kredit risk and default risk.

Source : http://www.pefindo.com/index.php/pageman/page/corporates-ratings-
reports.php?id=442
e. Yield-curve, or maturity, risk
The yield curve risk is the risk of experiencing an adverse shift in market interest
rates associated with investing in a fixed income instrument. When market yields
change, this will impact the price of a fixed-income instrument. When market interest
rates, or yields, increase, the price of a bond will decrease, and vice versa.
The yield curve risk is associated with either a flattening or steepening of the yield
curve, which is a result of changing yields among comparable bonds with different
maturities.

Example :
a. Flattening Yield Curve
 The Treasury yields on a 2-year note and a 30-year bond are 1.1% and 3.6%,
respectively. If the yield on the note falls to 0.9%, and the yield on the bond
decreases to 3.2%, the yield on the longer-term asset has a much bigger drop
than the yield on the shorter-term Treasury. This would narrow the yield spread
from 250 basis points to 230 basis points.
b. Steepening Yield Curve
steepening yield curve can be seen in a 2-year note with a 1.5% yield and a 20-
year bond with a 3.5% yield. If after a month, both Treasury yields increase to
1.55% and 3.65%, respectively, the spread increases to 210 basis points, from
200 basis points.
Source : https://www.investopedia.com/terms/y/yieldcurverisk.asp
f. Inflation, or purchasing-power, risk
Inflation risk, or purchasing power risk, arises because of the variation in the value of
cash flows from a security due to inflation, as measured in terms of purchasing power.
Example :

As fixed income securities, conventional bonds are negatively correlated with

inflation, meaning they are adversely impacted by consumer price increases. We
looked back over the 15 years from January 1, 1997 to December 31, 2011 and found
that fixed income securities, as measured by the Barclays Capital US Aggregate Bond
Index, had a -0.17 correlation with inflation (see chart below).
In addition, today’s bond yields are suppressed by the Federal Reserve Board’s
policy of maintaining rock-bottom short-term interest rates. For instance, if you
purchase a 10-year Treasury and hold it until maturity you are locking in an annualized
nominal return of approximately 2%, or 1.3% on an after-tax basis, assuming a 35%
 federal tax rate. Even if inflation is only 2% during that period (and inflation averaged
2.99% from January 1, 1926-December 31, 2011, according to Ibbotson), that’s a
negative return in real terms.
Source : https://www.forbes.com/sites/greggfisher/2012/03/05/hedging-
inflation/#2d2951de43d0
g. Liquidity risk
Liquidity risk is the risk that the investor will have to sell a bond below its true value
where the true value is indicated by a recent transaction. The primary measure of
liquidity is the size of the spread between the bid price and the ask price quoted by a
dealer. The wider the bid-ask spread, the greater is the liquidity risk.
Example :

The PIMCO Shor term Corporate Bond in the red box, which is quoting a price of
101.00/101.21 for Pimco bond, is indicating a willingness to buy the bond at 101.00
(the bid price) and sell it at 101.21 (the asked price). The range of the bid and price is
not too large, but if the pimco bond has bid-ask price is 100.00/102.00, it means that
the liquidity of the bond is high.
Source : https://www.investing.com/etfs/pimco-shterm-hyld-corp-bond-source
Another example, In the summer of 2013, for example, when Fed chair Ben
Bernanke hinted at a possible slowdown in the pace of Fed bond purchases, the bond
market reacted violently in what was described as a “taper tantrum.” Another example
is the Oct. 15, 2014, “flash rally” in which the 10-year on-the-run U.S. Treasury
experienced an incredible 40 basis point movement in a single day for no apparent
reason. According to a report released by the U.S. Treasury Department, it seems that
for a brief period of time there were far more trades to buy Treasuries than trades to
 sell. That this happened in the most liquid of all bond markets raises a concern with
other less-liquid bond markets.
Source : https://fredblog.stlouisfed.org/2015/10/illiquidity-in-the-bond-market/
h. Exchange-rate, or currency, risk
The dollar cash flows are dependent on the foreign-exchange rate at the time the
payments are received.Currency risk does not arise only from holding a foreign
currency bond issued by an overseas entity. It exists any time an investor holds a bond
that is denominated in a currency other than the investor’s domestic currency,
regardless of whether the issuer is a local institution or a foreign entity.
Example :
a U.S. investor who purchased EUR 10,000 face value of a one-year bond, with a three
percent annual coupon and trading at par. The euro was flying high at the time, with an
exchange rate versus the U.S. dollar of 1.45, i.e. EUR 1 = USD 1.45. As a result, the
investor paid $14,500 for the euro-denominated bond. Unfortunately, by the time the
bond matured a year later, the euro had fallen to 1.25 against the U.S. dollar. The
investor therefore received only $12,500 upon converting the maturity proceeds of the
euro-denominated bond. In this case, the currency fluctuation resulted in a $2,000
foreign exchange loss.
Source : https://www.investopedia.com/articles/investing/062813/how-currency-risk-
affects-foreign-bonds.asp
i. Volatility risk
The risk that a change in volatility will adversely affect the price of a security is called
volatility risk. The volatility here is related with the inflation and interest rate.
Example : from the picture below, these are the reasons why the graphic is volatile
(going up and down).

Source : https://www.blog.invesco.us.com/market-volatility-and-fixed-income
 The investor concerns that inflation is finally showing signs of life have helped
drive interest rates higher and impacted credit markets, where worries over
higher interest rates (and their potential impact on companies) have caused
declines in bond markets and other risky assets.
 The investors may have been underpricing inflation and that signs of potential
price pressures could disrupt markets. Inflation is a risk we are monitoring
closely. This is because concerns over inflation could incentivize the US
Federal Reserve (Fed) to hike interest rates faster and higher than previously
expected. Tighter monetary policy could tighten overall financial conditions,
which could be negative for financial markets.
 There has been little realized inflation, but recent volatility suggests that bond
investors are beginning to worry that inflation will rise sharply on the back of
strong growth boosted by tax cuts in a late-cycle economy.
 inflation forecast for 2018 (1.8%) suggests that inflation is unlikely to rise
quickly to a level that will concern the Fed. We do not believe that inflation is
dead, but we do not think it is likely to become a driving factor of monetary
policy soon.
 recent market moves have been driven more by investor repositioning than
major changes in economic fundamentals or financial conditions. These moves
 may have been reinforced by certain financial products that are sensitive to
changes in volatility.
j. Political or legal risk
Political or legal risk is The possibility of any political or legal actions adversely
affecting the value of a security
Example :

In 2017 The foreign inflow in bond has increased because of these factors :
 First, international rating agency Standard & Poor's (S & P) raised Indonesia's
debt rating to be investment grade.
 Secondly, the administration of President Joko Widodo received an unqualified
opinion on the Central Government Financial Report (LKPP) from the Supreme
Audit Agency. This status shows clean and reliable government work.
 In terms of the government itself, Indonesia's economic condition going
forward still has bright prospects. This is reflected in the macroeconomic
assumptions for next year, which illustrate the most optimistic state of
Indonesia during President Joko Widodo's term.

This can be seen from foreign funds entering the Indonesian stock and bond market
which is still increasing since the beginning of this year. It was recorded that there was
a capital inflow of IDR 28.22 trillion to the stock market since the beginning of the year
until May 22, 2017. In the same period, the flow of foreign funds into the bond market
amounted to IDR 74.56 trillion.
 Source : https://www.bareksa.com/id/text/2017/05/23/survei-analis-pengaruh-panasnya-
politik-terhadap-pasar-keuangan-indonesia/15579/news
k. Event risk
Event risk is the ability of an issuer to make interest and principal payments is seriously
and unexpectedly changed by a natural or industrial accident or a takeover or corporate
restructuring.
Example :
In 2014 TXU got bankruptcy because of the restructurimg. The Caesar’s
restructuring will see a wide range of outcomes for its bondholders. There are 3 main
issuing entities (Caesar’s Entertainment Operating Co, Caesar’s Entertainment Resort
Properties, and Caesar’s Growth Properties) and it should be noted the proposed
restructuring will focus on only one of the entities (Caesar’s Entertainment Operating
Co). The capital structure is a product of a range of re-financings, asset swaps, equity
issues and other layers of financial engineering over the years.
As the restructuring end-game came closer in 2014, the different position in the
capital structure was also reflected in the price performance of the bonds. The
unsecured claims, whilst already trading at distressed levels at the start of 2013, saw a
further market-to-market loss of around 75% over the following 2 years.
 Source : https://www.bondvigilantes.com/blog/2015/01/06/default-case-study-ave-
caesar-morturi-te-salutant/

l. Sector risk
Bonds in different sectors of the market respond differently to environmental changes
because of a combination of some or all of the preceding risks, as well as others. The
possibility of adverse differential movement of specific sectors of the market is called
sector risk.
Example : Every sector industry has different return and risk. As we know from the
picture that every sector has different risk and return. For the example the municipal
bond and corporate bond has different risk and return. As the higher income has the
higher risk, The municipal bond’s return is only 4,6% and the risk is -3,7% meanwhile
the corporate bond’s return is 11,5% and the risk is -8,3%.

Source : https://www.schwab.com/resource-center/insights/content/the-elements-of-a-
diversified-bond-portfolio