Fixed Income

Risks Associated with

Investing in Bonds
Reading - 53

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Interest Rate Risk

Facts:
The price of the bond is inversely proportional to Interest rate
or yields.
Hence, this raises the risk for bondholder known as the
interest rate risk.

A bond will trade at par if the coupon rate is equal to the

required yield by market.
If coupon rate > yield required by market then, Price > par
value.

If coupon rate < yield required by market then, Price < par
value.
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Interest Rate Risk

Example:
Par value = Rs.100
Coupon Rate = 6%, 20 year bond
Yield required by market = 6.5%
Price of bond = Rs.94.45
Settlement Date
= 15-03-1990

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Features of bond affecting Interest Rate Risk

Impact of Maturity
Longer the maturity of bond, greater is the bonds price
sensitivity to change in interest rate.
Example:
Case - I
Par value = Rs.100
Coupon Rate = 7%, 20 year bond
Yield required by market = 7.5%
Price of bond = Rs.94.86
Change = -5.14%

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Case - II
Par value = Rs.100
Coupon Rate = 7%, 5 year bond
Yield required by market = 7.5%
Price of bond = Rs.97.95
Change = -2.05%

Features of bond affecting Interest Rate Risk

Impact of Coupon Rate
Lower the required rate, greater is the bonds price sensitivity to
change in interest rate.
Example:
Case - I
Par value = Rs.100
Coupon Rate = 8%, 20 year bond
Yield required by market = 6.5%
Price of bond = Rs.116.66

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Case - II
Par value = Rs.100
Coupon Rate = 8%, 20 year bond
Yield required by market = 7%
Price of bond = Rs.110.68

Features of bond affecting Interest Rate Risk

Impact of Embedded Options
The sensitivity of bond price of a bond (with embedded option),
with the change in interest rate depends on the changes of value
of embedded option with the change in interest rate.
Price of Callable Bond = Price of Option-Free Bond Price of Embedded Call Option

Considering the above formula we can say:

When the interest decline, the price of the bond with
embedded call option may not increase as much as an
otherwise an option free bond.
When the interest increases, the price of the bond with
embedded call option may not decrease as much as an
otherwise an option free bond.
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Impact of Yield Level

Higher the bonds yield, lower is its price sensitivity.
Example:
Case - I
Par value = Rs.100
Coupon Rate = 8%, 20 year bond
Yield required by market = 6.5%
Price of bond = Rs.116.66

Case - II
Par value = Rs.100
Coupon Rate = 8%, 20 year bond
Yield required by market = 7%
Price of bond = Rs.110.68

Other things held constant, if

the yield increases by 100 basis
points then,

Other things held constant, if

the yield increases by 100 basis
points then,

Yield required by market = 7.5%

Price of bond = Rs.105.14
% Change in Price = -9.87%

Yield required by market = 8%

Price of bond = Rs.100
% Change in Price = -9.65%

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Interest Rate Risk for Floating-Rate Securities

Factors causing fluctuations in price of floating-rate securities:
Longer the duration between current and next coupon reset
date, higher is the possibility of price fluctuation.

If there is a change in the required margin of investors, the

price of floating-rate security might fluctuate.

The floating-rate securities usually have a cap which might

result in fluctuation of the price based on different situations.
The risk for a floating rate security is known as cap risk

Note:
The coupon rate is set periodically, based on the prevailing market
interest rate that is used as a reference rate plus a quoted margin.
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Measuring Interest Rate

Price change of bonds can be seen in terms of:
Percentage change in price from initial price.
Absolute price change from initial price.

The change in yield is

referred as
Rate Shock

Percentage Price change

It is calculated by taking average of percentage change in price
resulting from an increase and a decrease in interest rates by
same number of basis points.
Approximate percentage change for a 100 basis
point change in yield
Price if yield decline - Price if yield rise
2 x Initial Price x Change in yield in decimal
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Measuring Interest Rate

Example:
Suppose a bond is currently selling at Rs.94 to yield 7%. Now if
the interest rate shoots up by 50 basis points, the price of the
bond declines to Rs.92 and if the interest rates take a dip by 50
basis points, the price of the bond increases to Rs.97. Estimate
the approximate percentage price change for a 100 basis point
change in yield.
Solution:
% change in price for a 100 basis
point change in yield
= (97 92)/[2 x 94 x .005]
= 5.31%
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Note:
Percentage price change for a 100
basis point change in yield is called
Duration.

Duration is a measure of price

sensitivity of a bond to a change in
yield.
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Yield Curve
The graphical depiction of the relationship between the yield and
maturity is known as yield curve.
Bond Portfolio

Parallel shift in yield curve of +50 basis points

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Yield Curve
Non-Parallel shift in yield curve of +50 basis points

Shift in Yield Curve

Parallel shift in Yield Curve
Non-Parallel shift in Yield Curve

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Call or Prepayment Risk

A bond that includes a call option allows the issuer to call all or a
part of the issue prior to maturity. Reason why they would
exercise the call option:
If the issuer receives surplus cash with no investment
opportunities, they may wish to repay their debt thus saving
on interest.
If interest rates fall, the issuer may wish to refinance existing
debt at a lower interest rate. They can do this by repaying the
existing debt and issuing new debt at the lower interest rate.
Disadvantages of a callable security
Cash Flow is uncertain
Reinvestment Risk
Price compression
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Reinvestment Risk
It refers to the risk that the interim cash flows received from a
bond which are available for investing again might have to be
invested at a rate lower than the rate at which they were
invested previously.
A security has more reinvestment risk when:
It carries a higher coupon rate then prevailing market rate.
It has a call or prepayment option.
It is an amortizing security.
Note:
A Zero coupon bond has zero
investment risk but this
advantage is offset by their
greater duration and interest
rate risk.
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Credit Risk
Default risk is the risk that an issuer will fail to perform on its
obligations under the terms of a bond contract with respect to
the timing of payments, and the amount owed to investors.
Credit risk reflect the riskiness of an investment as perceived
by the market.
Credit Risk = Yield on a risky bond Yield of risk free bond

An increase in credit risk will translate into an increase in the

required yield and force the bonds price to lower. This is
known as credit spread risk.
Downgrade risk is the risk that credit rating agencies will
downgrade the credit rating of a particular issue.
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More Risks
Liquidity Risk: It the risk that an investor has to sell his
investments at a lower price than its indicated value.

Exchange Risk: It refers to the risk of receiving a lower amount at

maturity of a foreign currency denominated bond than invested
to acquire the bond.
Inflation Risk: It refers to the declining in the purchasing power
of the securitys cash flows due to inflation.
Event Risk: A natural disaster may impair issuers ability to satisfy
debt obligations.

Sovereign Risk: It is a risk that a foreign government may be

unable to satisfy its debt obligations.
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