1、Risks Associated with Investing in Bondsby Frank J. Fabozzi,Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlaw

2、ful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the us

3、e of these programs or from the use of the information contained herein.,PowerPoint Slides by David S. Krause, Ph.D., Marquette University,Chapter 2 - Risks Associated with Investing in Bonds,Major learning outcomes: Understand the various risks associated with investing in bonds: Interest rate Call

4、 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, liqui

5、dity 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 bonds coupon rate, yield required by the market, and price relative to par value (i.e.,

6、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 le

7、vel 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 bo

8、nd. 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 th

9、e 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

10、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 inv

11、estors 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 vol

12、atility 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 ris

13、k 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 P r Yield,Longer term bonds are more sensitive to changes in interest rates than shorter term bo

14、nds.,Inverse, non-linear shape,Interest Rate Risk,Key relationships: a bonds coupon rate the yield required by the market the bonds 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

15、 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

16、 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

17、of a bond that affect interest rate risk: Maturity Coupon rate Embedded options A bonds 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 bonds maturity

18、, the greater the bonds 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 sam

19、e 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

20、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%

21、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?,Greater price change,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, compou

22、nded annually. What are the price sensitivities of these bonds to a 1% increase (decrease) in bond yields?,Volatility of Bonds with Different Coupon Rates,Greater price change,Embedded Options Impact Interest Rate Risk,No hard and fast rule applies. The value of a bond with embedded options will cha

23、nge 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 i

24、ssuer 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 exer

25、cised 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

26、 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 mar

27、ket 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 L

28、evel,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 bonds yield impact price sensitivity for a change in market rates, holding all other factors the same? The higher a bonds yield, the lower the

29、 bonds 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

30、 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 bonds coupon rate is different from the prevailing market interest rate. For floating

31、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

32、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, t

33、he 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 bonds price will decline (increase). Thi

34、s 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 rese

35、t at a cap rate below the market interest rate, the bonds price will decline. In fact, once the cap has been reached, the bonds 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

36、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 t

37、he 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 chan

38、ge 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 valuati

39、on 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

40、 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

41、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

42、.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 bonds change in price, when interest rates change using the approximate percentage price change of a bond approach. In

43、 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 bonds sensitivity to interest rate changes. Well also learn how to compute and interpret a bonds convexity. For now, this method is a reasonable appro

44、ximation 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 d

45、uration.,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 o

46、n 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 cur

47、ve 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

48、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%.,Greatest change for lower coupon, longer maturity, lower yield,Yield Curve Risk,Exhibits 1 and

49、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 ri

50、sk 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 portfolios value for a 100 basis point change in the yield for all maturities.,Yield Curve Risk,The yield curve is actual

51、ly 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

52、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 investors perspective: The cash flow pattern of a callable bond is not known with certainty because it is not known when the bond wi

53、ll be called. Because the issuer is likely to call the bonds when interest rates have declined below the bonds 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 th

54、at 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. The price appreciation potential of the bond will be reduced relative to a comparable option

55、-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 ris

56、k: Default risk Credit spread risk 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 companys bond.,Credit Risk: Default Risk,Default risk is the risk that the issuer wi

57、ll 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

58、 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 yi

59、eld 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 risk