Fixed Income Analysis, Second Edition

CHAPTER 2

RISKS ASSOCIATED WITH INVESTING IN BONDS

I. INTRODUCTION

Armed with an understanding of the basic features of bonds, we now turn to the risks associated with investing in bonds. These risks include:

• interest rate risk

• call and prepayment risk

• yield curve risk

• reinvestment risk

• credit risk

• liquidity risk

• exchange-rate risk

• volatility risk

• inflation or purchasing power risk

• event risk

• sovereign risk

We will see how features of a bond that we described in Chapter 1—coupon rate, maturity, embedded options, and currency denomination—affect several of these risks.

II. INTEREST RATE RISK

As we will demonstrate in Chapter 5, the price of a typical bond will change in the opposite direction to the change in interest rates or yields.⁹ That is, when interest rates rise, a bond’s price will fall; when interest rates fall, a bond’s price will rise. For example, consider a 6% 20-year bond. If the yield investors require to buy this bond is 6%, the price of this bond would be $100. However, if the required yield increased to 6.5%, the price of this bond would decline to $94.4479. Thus, for a 50 basis point increase in yield, the bond’s price declines by 5.55%. If, instead, the yield declines from 6% to 5.5%, the bond’s price will rise by 6.02% to $106.0195.

Since the price of a bond fluctuates with market interest rates, the risk that an investor faces is that the price of a bond held in a portfolio will decline if market interest rates rise. This risk is referred ...