March 22 Chap

8/2/2019 March 22 Chap

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Fixed income analysis

Extracted from Fabozzi Chapter

Various Risks Associatedwith Investment in Bonds


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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


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Yield Curve Risk

Another key factor that affects the price sensitivity of a bond

(or a portfolio of bonds) is the change in market interestrates 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 abond 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 yieldcurve. Future chapters in the text continue the discussion of the yield curve

and yield spreads.

Duration


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Yield Curve Risk

The yield curve is actually a series of yields,one for each maturity.

Therefore to determine the impact of interestrate risk on a portfolio of bonds with differingmaturities, a rate duration is computed to

measure the impact of a rate change in atparticular maturity (i.e. 5-year rate).


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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 bondwill be called.

2. Because the issuer is likely to call the bonds wheninterest rates have declined below the bonds couponrate, the investor is exposed to reinvestment risk.

This is the risk resulting from the fact that interest earned from aninvestment may not be able to be reinvested in such a way thatthey earn the same rate of return as the invested funds thatgenerated them. For example, falling interest rates may preventbond coupon payments from earning the same rate of return asthe original bond.

3. The price appreciation potential of the bond will bereduced relative to a comparable option-free bond.


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Prepayment Risk for Mortgage-and Asset-Backed Bonds

The same disadvantages apply tomortgage- and asset-backed bondswhere the borrower can prepay

principal prior to scheduled principalpayment dates.

This is referred to as prepayment risk.


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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.


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Credit Spreads

The yield spread between Treasury andnon-Treasury bonds that are identical inall respects except credit rating is referred

to as the credit or quality spread.


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Credit Spreads

A credit spread or quality spread is the yieldspread between a non-Treasury security and aTreasury security that are identical in allrespects except for credit rating.

Some market participants argue that creditspreads between corporates and Treasurieschange systematically because of changes ineconomic prospectswidening in a decliningeconomy (flight to quality) and narrowing inan expanding economy.


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Credit Spreads

Credit spreads between Treasury andcorporate bonds change systematically withchanges in the overall economy.

Credit spreads widen (narrow) in a declining

(expanding) economy. Historical examples

Exhibit 4 shows the changes in credit spreads since1919

The spread is measured as the difference between the Baaand Aaa rated corporate debt

The relationship between macro-economic conditions andyield spread is clearly shown in the exhibit


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Credit Spreads


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Credit Risk: Default Risk

Default risk is the risk that the issuer will fail to satisfythe terms of the bond obligation with respect to thetimely payment of principal and interest.

The percentage of a population of bonds that isexpected to default is called the default rate.

A default does not mean the investor loses the entireamount invested, a percentage of the investmentmay be recovered. This is referred to as therecovery rate.


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Credit Risk: Credit Spread RiskEven if a bond issue does not go into default, there is the risk

that the market value of the bond will fall because thereturn demanded by the market has increased.

Recall that as the required yield increases, the price of abond falls. So even if interest rate do not change, it ispossible for a bond to fall in value if the level of credit riskspread increases.

The yield on a bond is made up of two components:The yield on a similar default (risk-free) bondA 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.


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Credit Risk: Credit Spread Risk(continued)

In the U.S. the Treasury security with the same maturity as therisky bond being evaluated is considered to be risk-free.

The risk premium or yield spread of a similar maturity bond is thedifference 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 anincrease in the credit spread is called the credit spread risk.

This risk is unique for individual companies, as well as for entireindustries and sectors. That is why bond analysts will focus onunderstanding the unique risks of individual sectors (i.e. utilities, autos,financial services, etc.)

The credit spread trends to increase during recessions anddecrease during economic expansions.


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Credit Risk: Downgrade Risk

Downgrades result when rating agencies lower theirrating on a bond for example, a change byStandard & Poors from a B to a CCC rating.

Downgrades are usually accompanied by bond pricedeclines. In some cases, the market anticipatesdowngrades by bidding down prices prior to the actualrating agency announcement.

Before bonds are downgraded, agencies often placethem on a credit watch status, which also tends tocause price declines.


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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 ofan issuer.

Investment grade bonds are less likely to have theirratings downgraded or to default than non-investmentgrade bonds.

While investment grade bonds may also bedowngraded or default, a bond with a higher rating isless likely to experience a downgrade or default.


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The quality of any bond is based on the issuer's financialability to make interest payments and repay the loan infull at maturity.

Rating services help to evaluate the creditworthiness ofbonds. Some bonds, such as municipal bonds, may be

insured by third parties.


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Credit Risk: Bond Ratings

The bond market can be divided into twosectors: the investment grade and non-investment grade markets as summarized

below:


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Credit Risk: Bond Ratings

A popular tool used by managers to gauge the prospects of an issuebeing downgraded or upgraded is a rating transition matrix. This issimply a table constructed by the rating agencies that shows thepercentage of issues that were downgraded or upgraded in a giventime period.

The table can be used to approximate downgrade risk and defaultrisk.


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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 recenttransaction.

The primary measure of liquidity is the size ofthe spread between the bid price (what thedealer is willing to pay) and the ask price(what the dealer is willing to sell).

A liquid market is generally defined by a smallbid-ask spread which does increase materiallyfor large transactions.


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Liquidity Risk

Bid-ask spreads are computed bylooking at the best bid and lowest ask.

This liquidity measure is called themarket bid-ask spread.

Exhibit 5 shows bid-ask spreads for asingle security.


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Liquidity Risk


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Liquidity Risk

Marking Positions to Market: Liquidity risk is not a great concern for non-

institutional investors who will be holding theposition to maturity.

However, even if an institutional investorintends to hold the security until maturity,they are likely required to periodically mark

the position to the market. With a bond thathas low liquidity, the highest bid might be alow price take would result weak reportedperformance.


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Liquidity Risk

Changes in Market Liquidity: Bid-ask spreads change over time, which

result in changes in liquidity risk.

Because new offerings and products arebeing created, the supply and demanddynamics can cause bid-ask spreads to

change. For instance, the exit or entry of amajor investor can decrease or increase therelative amount of liquidity for an issue.


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Inflation Risk

Inflation orpurchasingpower risk arisesfrom the declinein the value of abonds cashflows due toinflation.

Inflation volatilityis a closelywatchedmeasure.


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Volatility Risk

Volatility risk is the risk that the price of a bondwith an embedded option will decrease whenexpected yield volatility changes.

Basic option valuation concept: The price of anoption increases with more volatility of theunderlying asset, all things equal.

Therefore, changing yield volatility affects theprice of a bond with an embedded option The greater the expected yield volatility, the greater

the value (price) of an option.


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Volatility Risk

The price of a callable bond is equal to the price of anoption-free bond minus the price of an embedded calloption.

If expected yield volatility increases, all else the same, theprice 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 anoption-free bond plus the price of an embedded putoption.

If expected yield volatility decreases, all else the same, theprice of an embedded put option will decrease resulting in adecrease in the price of a putable bond.


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Volatility Risk

The risk that the price of a bond with an embeddedoption will decline when expected yield volatilitychanges is called volatility risk.

Below is a summary of the effect of changes in expectedyield volatility on the price of callable and putable bonds:


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Event Risk

Occasionally an issuer is unable to makeeither interest or principal payments becauseof 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


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Sovereign Risk

Sovereign risk is the risk that, as the result ofthe actions of a foreign government, theremay be either a default or an adverse pricechange even in the absence of a default

Currency revaluations, political change, or war canresult in a change in credit risk

Sovereign risk has two components:

Unwillingness of a foreign government to payprincipal or interest

The inability of a foreign government to pay

Documents

March 22 Chap