Bond Risk

Risks of Fixed Income

Securities
O Systematic Risks
O Interest Rate Risk
O Reinvestment Risk
O Purchasing Power Risk
O Exchange Rate Risk
O Unsystematic Risks
O Default (Credit) Risk
O Call Risk
O Liquidity Risk
2

Bond Risk & Rating Agencies

O Standard & Poors
O Moodys

Standard Credit Rating

System
Bonds

Standard & Poors

Moodys

Investment Grade:
qHigh Grade
qMedium Grade

AAA - AA

Aaa - Aa

A - BBB

A - Baa

BB - B

Ba - B

CCC - D

Caa - C

Non-Investment Grade:
qSpeculative
qDefault

Overall Range

AAA - D

Aaa - C

Bond Pricing Formula

(Coupon bonds)

1.SemiannualInterestpayment=Pmt = 58.75
2.Numberofpaymentsto call=n = 5 x 2 = 10
3.FaceValue=FutureValue=FV = $1000
4.PresentValue=CurrentPrice=PV = 1217.50
(must be input as a negative number)
5. Yield to Call = CPT I% = 6.58%
5

Bond Price and Interest Rates

InterestRate

BondPrice

8.48%
Up50basis
points:8.98%

$1217.50
$1180.32(-$37.18)

Up75basis
points:9.23%

$1162.26(-$55.24)

Down50basis
points:7.98%

$1256.40($38.90)

Down75basis
points:7.73%

$1276.46($58.96)
6

Bond Price and Interest Rates

P
r
i
c
e

Note the asymmetry in the relation.

Bond prices are more sensitive to
drops in interest rates.

Interest Rate
7

Fig. 2
Bond A: Higher Convexity
B
o
n
d
P
r
i
c
e

Bond A is more interest rate sensitive:

better for both increases and decreases
in rates. For decreases (increases ) in
rates, it gains (loses) more (less).

Convexity
Bond B: Lower Convexity
Bond B is less interest rate sensitive: for
decreases (increases) in rates, it gains
(loses) less (more).

A
B

Yield
Yieldtotomaturity
maturity

Convexity is a more accurate measure of interest rate sensitivity

than Duration. Bond A is more convex and sell at a higher price.

Interest Rate Risk of bonds

Price Risk
Inverse relation between
bond price and interest
rates.

Can be eliminated
by holding the
bond to maturity.

These are affected

oppositely by
changes in interest
rates. Can they be
offset? Yes

Decreases in
interest rates
favorable, and vise
versa.

To eliminate interest rate

risk hold a zero coupon

bond to maturity.

Reinvestment Risk
Direct relation between
coupon renvestment income
and interest rates.

Can be eliminated
by holding zero
coupon bonds.

DURATION

Increases in
interest rates
favorable, and vise
versa.

To eliminate interest rate

risk offset price and

reinvestment risk.

Duration isthepointintimeinabondslife
where the price risk and reinvestment risk
offset each othersothatthebondis
immunizedagainstinterestraterisk.
So, to immunize a bond against interest
rate risk, hold it to its duration.
For a zero coupon bond, duration is
equal to maturity.
10

Duration &
Immunization
O Duration a concept developed by

Fred Macaulay in 1938 that provides

a time-weighted measure of a
securitys cash flows in terms of
payback
O Immunization the concept of
minimizing the impact of changes in
interest rates on the value of
investments
11

Duration
Durationisaveragematurityofacouponbond.
Durationisarisk-management strategyinfixed
incomeinvestment.
Immunization strategy requires that
expected yield on the bond = realized yield

12

Rules of Duration:
1.DurationofaZero-coupon(nointerestpayment)
bondisequaltomaturity;
2.Durationishigherwhencouponrateislower.
3.Durationusuallyriseswiththebondsmaturity.
4.Durationofacouponbondishigherwhenits
YTMislower.
13

5.Acouponbondcanbeconsideredtobeaseries
ofzero-couponbondswherethematurityofeach
zeroisequaltothetimewhenthecashflowoccurs;
6.Durationofaportfolioofbondsisequaltothe
weightedaverageofthedurationofindividual
bonds.

14

7. Price change in a bond :

P
= _
P
Change in
Price

D
(1 + y) y

Change in Yield to
maturity y

D is duration in years,
y is Yield to maturity

8.The change in price of a bond in response to a

change in interest rates is proportional to its
modified duration; longer the modified duration,
larger the price change.
15

D
= D*
(1 + y)
P = _ D* * P y
Change in
Price

D* is modified
duration in years,

Modified Duration
Change in YTM

Price of
bond

16

9.A bond is immunized against interest rate

risk if the holding period (investors decision)
is equal to its duration.

So, to immunize the bond against interest

rate risk, sell the bond at 4.4 years or 4
year and 4 months.
At this point, the realized yield on the
bond will be equal to the promised yield
for small changes in interest rates.
17

Duration
Examples:
a. Price change in the 5-year bond for a 50 basis
increase in yield to maturity from 6.5% to 7.0%
y = 0.5% = 0.005
_ D* * P y
P
=
y = 0.5%; P = 1031.17;
= - (4.13)(1031.17)(.005)
D
4.4
*
D = (1 + y) = 1.065 = 4.13 = - $21.3 (loss)
18

b.Changeinpricefora10yearzero coupon bondfora

100basispointsdecreaseininterestrateorytm(=8%).
Note that the duration of a zero is equal to its maturity.
1000
P
=
= $463.2
Price of this bond:
10
(1.08)
y = 100 basis points = 1% P = _ D* * P y
= - 0.01
= - (9.26)(P)(-.01 )
D
10
= (463.2)(0.0926)
*
D = (1 + y) = 1.08 = 9.26
= $43
19

10. Duration of a portfolio of bonds:

Dp = wi* Di)
where wi and Di are the portfolio weights in market
value and the Duration of the ith bond.

20

Duration
Investment Strategy:
Duration is longer for long maturity and low

coupon bonds, and vice versa.

When interest rates are expected to decline, bond

prices increase. Switch to long duration (long

maturity and low coupon rate) bonds. And,when
interest rates are expected to go up, switch to short
duration bonds.
21

Uses for Duration

O Providing a measure of a bonds

volatility
O Estimating the change in the price of
a bond based on changes in interest
rates
O Immunizing a bond or bond portfolio
against interest rate risk

22

Convexity: Note the

curvature. Shows that
bonds gain more in
response to interest
rate decreases, and
lose less in response
to increases in rates.

B
o
n
d
P
r
i
c
e
Duration: shows
change in bond
price against
interest rate
changes. Note
the linear
relationship.

Fig. 1

Actual bond
prices behave
this way

Yield to maturity

Duration vs. Convexity

23

Bond Price change using Duration

P
= _
P
Change in
Price

D
(1 + y) y

Change in Yield to
maturity y

D is duration in years,
y is Yield to maturity

Bond Price change using Convexity

P
= _
P

D
1
y)2]
x
Convexity
x
y
+
[
(1 + y)
2
Additional term due to Convexity

24

Convexity
1
[ x Convexity x y)2]
2

y negative; Bond price

increases.
Convexity term increases
price gain through y)2
and the effect is bigger
for higher Convexity.

y)2 is always
positive regardless of
sign of y
Convexity term is always
positive and higher for
higher Convexity

y positive; Bond price

drops.
Convexity term reduces
price drop through y)2
and the effect is bigger
for higher Convexity.
25

Always choose high Convexity Bonds

CreditRisk
T-Bill

None

PriceRisk
Noneif held

ReinvestmentRisk

None

to maturity

T-Strips

None

Noneif held

T-Bonds

None

Noneif held

InflationIndexedBonds

None

Noneif held

None

to maturity

to maturity

Yes-
unavoidable

Negligible

to maturity

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