Fixed income analysis

Various Risks Associated with Investment in Bonds

Extracted from Fabozzi Chapter

 Major learning outcomes:

Understand the various risks associated with investing in bonds:
Interest rate, Yield curve Reinvestment Call and prepayment Credit Liquidity Exchange-rate Inflation Volatility Event Sovereign

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 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.
Future chapters in the text continue the discussion of the yield curve and yield spreads. Duration

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).

Call and Reinvestment Risk

There are three disadvantages to call provisions from an investors 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 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 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 Mortgageand 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

It is important that you be able to evaluate credit risk.

Credit Spreads
The yield spread between Treasury and non-Treasury bonds that are identical in all respects except credit rating is referred to as the credit or quality spread.

Credit Spreads
A credit spread or quality spread is the yield spread between a non-Treasury security and a Treasury security that are identical in all respects except for credit rating. Some market participants argue that credit spreads between corporates and Treasuries change systematically because of changes in economic prospectswidening in a declining economy (flight to quality) and narrowing in an expanding economy.

Credit Spreads
Credit spreads between Treasury and corporate bonds change systematically with changes in the overall economy.
Credit spreads widen (narrow) in a declining (expanding) economy. Historical examples Exhibit 4 shows the changes in credit spreads since 1919
The spread is measured as the difference between the Baa and Aaa rated corporate debt The relationship between macro-economic conditions and yield spread is clearly shown in the exhibit

Credit Spreads

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: 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 yield 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 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 issuers bonds will decline due to an increase in the credit spread is called the credit spread risk.
This risk is unique for individual companies, as well as for entire industries and sectors. That is why bond analysts will focus on understanding the unique risks of individual sectors (i.e. utilities, autos, financial services, etc.)

The credit spread trends to increase during recessions and decrease during economic expansions.

Credit Risk: Downgrade Risk

Downgrades result when rating agencies lower their rating on a bond for example, a change by Standard & Poors 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 noninvestment 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 noninstitutional 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.

Inflation Risk
Inflation or purchasing power risk arises from the decline in the value of a bonds cash flows due to inflation. Inflation volatility is a closely watched measure.

Volatility Risk
Volatility risk is the risk that the price of a bond with an embedded option will 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:

Event Risk
Occasionally an issuer is unable to make either interest or principal payments because of unexpected events, such as
A natural catastrophe or disaster, such as a hurricane or industrial accident A corporate takeover or restructuring that prevents the issuer from making timely payment A regulatory change that delays or prevents an issuer from being able to make payment
EPA or ERISA regulatory changes New rules for financial services, utilities, or insurance companies could impact the ability to make payment

Sovereign Risk
Sovereign risk is the risk that, as the result of the actions of a foreign government, there may be either a default or an adverse price change even in the absence of a default
Currency revaluations, political change, or war can result in a change in credit risk

Sovereign risk has two components:

Unwillingness of a foreign government to pay principal or interest The inability of a foreign government to pay