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Level 56

Risks Associated with Investing in Bonds


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High maturity --> high interest rate risk (duration)
Explain how bond maturity, coupon, embedded options, yield level affect its interest rate risk
Callable bond value
callable bond value = value of option-free bond - value of embedded call option
interest rate risk of a floating security
floating-rate securities have coupon rate floats (periodically reset based on reference rate - either Treasury rate or LIBOR)
duration
same as interest rate risk
yield curve risk
portfolio - occurs when, if interest rates increase by different amounts at different maturities for different bonds, the portfolio's value will be different than if interest rates increase same amount
duration vs maturity
bond with longer maturity has the greater duration because it will have greater % change in value for a given change in yield
duration vs coupon rate
bond with higher coupon rate has lower duration - price of bond with higher coupon rate will change less for a given change in yield than price of lower coupon bond will
duration vs put/call option
a call feature limits the upside price movement of bond when interest rate declines bond price will not rise above bond price --> value of a callable bond will be less sensitive to interest rate changes than option-free bond
disadvantage of callable/prepayable security
bonds with call provisions and securities with prepayment options offer much less certain cash flow streams
reinvestment risk
lower coupon rate increases duration but decreases reinvestment risk. Instances of reinvestment risk:
bond rating
indicates probability of default (issuer not making timely principal and interest payments as promised in the bond indenture)
Credit risk
possibility that borrower will not meet the scheduled repayments and default on their loan
credit risk - credit spread
risky bond yield = default-free bond yield + credit spread
credit risk - downgrade risk
risk that the credit rating agency will lower a bond's rating --> lower bond price
Liquidity risk
Risk that a security can only be sold by incurring large transaction costs. Easiest to sell are large cap issues traded on NYSE. Small cap stocks are inactively traded and have a high level of liquidity risk.