Bond Valuation

Risks in Bonds

Risks Associated with Investing in Bonds

Major learning outcomes:

Understand

the various risks associated with investing in bonds: Interest rate Call Reinvestment Liquidity Exchange-rate Inflation

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. Longer maturity period Greater sensitivity of price to changes in interest rates

Inflation Risk

Inflation or purchasing power risk arises from the decline in the value of a bonds cash flows due to inflation.

When an investor buys a bond, he or she essentially commits to receiving a, either fixed or variable, for the duration of the bond or at least as long as it is held

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.

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).

There is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond.

Call Risk The risk that a bond will be called by its issuer. Callable bond have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rate have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs. Reinvestment Risk The risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120(12%*$1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond.

Yield Curves and

Term Structure Theory

The Yield Curve

A yield curve is a graphical presentation that shows the yield to maturity for treasury securities of various maturities at a particular date. plot of maturity vs. yield slope of curve indicates relationship between maturity and yield

yield

yield yield

maturity Upward sloping

maturity Downward sloping Flat

maturity

Determinants of term structure of interest rates

Three theories are proposed to explain the evolution of spot rate curves:

1. Expectations Theory;
2. Liquidity preference Theory;

3. Market Segmentation Theory.

Expectations theory

This theory holds that the shape of the yield curve can be explained by the interest rate expectations of those who participate in the market. The expectations theory holds that any long term rate is equal to the geometric mean of current and future one year rates expected by the market participants.

Liquidity preference

For bank deposits, depositors usually prefer short-term deposits over long-term deposits since they do not like to tie up capital (liquid rather than tied up). Hence, long-term deposits should demand high rates.
For bonds, long-term bonds are more sensitive to interest rate changes. Hence, investors who anticipate to sell bonds shortly would prefer short-term bonds.

Market segmentation

The market for fixed income securities is segmented by maturity dates.

To the extreme, all points on the spot rate curves are mutually independent. Each is determined by the forces of supply and demand.
This theory deals with the supply and demand in a certain maturity sector, which determines the interest rates for that sector.

Determinants of Interest Rates

Short term risk free rate Inflation rate Real growth rate Time preferences

Maturity premium Future expectations Liquidity preferences Prefered habitat

Interest Rate

Default premium Business risk Financial risk Collateral

Special features Call/put features Conversion features Other features

Short term risk free interest rate

The short term risk free interest rate is the yield on a one year government security, say 364 days Treasury bill. Short term risk free interest rate = expected real rate of return + expected inflation

Maturity premium
Maturity premium represents the difference between the yield to maturity short term risk free security and the yield to maturity on a risk free security of a longer maturity.
Yield to maturity

Time to maturity

Default premium While there is no risk of default on government securities, corporate bonds may default on interest and or principal payment. When such a possibility exists, investors will ask for a default premium in addition, of course, to the maturity premium.

Special Features

A call features raises the interest rate because the investors are exposed to call risk. A put features lowers the interest rate because the investors enjoy the put option. A conversion feature lowers the interest rate because the investors enjoy the option to convert.