Risks Associated With Investing In Bonds Flashcards
Interest rate risk
When the price of a bond held in a portfolio declines because of the rise in market interest rates
Reason for an inverse relationship between changes in interest rates and bond prices
If interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price
Corporate rate less than yield required by market
price less than par value
Par value
Corporate rate greater than yield required by market
Price is greater than par value
premium
Impact of maturity
The longer the bonds maturity, the greater the bond’s price sensitivity to changes in interest rates
Impact of coupon rate
The lower the coupon rate, the greater the bond’s price sensitivity to changes in interest rates
Impact of embedded options
Change depending on how the value of the embedded options changes when interest rate changes
Embedded call option
A benefit to the issuer and a disadvantage to the bondholder
subtracted from the option free Bond
Option free Bond
Once the embedded call option is deducted, it increases when interest rates decline
Duration
A measure of the price sensitivity of a bond to a change in yield
Yield Curve risk
Affect the price sensitivity of a portfolio of bonds
an adverse shift in market interest rates
Impact of yield level
The higher the bond yield, the lower the price sensitivity
Measuring interest rate risk
Percentage price change from initial price
dollar price change from initial price change
Rate shock
Change in yield basis points
Call risk
The risk for a bond buyer that exists in purchasing a callable bond
Prepayment risk
The risk involved with the premature return of principal on a fixed income security
Reinvestment risk
The possibility that an investor will be unable to reinvest cash flows received from an investment
Types of credit risks
Default risk
credit spread risk
downgrade risk
Default risk
The risk that an issuer will fail to satisfy the terms of the obligation with respect to timely payments
Credit spread rate
The risks that an issuers debt obligation would decline due to an increase in credit spread
Rating agency
A tool investors used to gauge the default risk of an issue is the credit ratings assigned to issues by rating company
Downgrade
A deterioration in the credit rating of an issue is penalized by the inferior credit rating
Upgrade
Improvement in the credit quality of an issue is rewarded with a better credit rating
Liquidity risk
The risk that the Investor will have to sell a bond below its indicated value
Currency risk
The risk of receiving less of the domestic currency when investing in a bond that makes payment in another currency
Inflation risk
Arises from the decline in the value of the security cash flow
Volatility risk
The risk that at the price of a bond with an embedded option will decline when a yield volatility changes
Volatility risk on options
Callable bonds: increase an expected yield volatility
Putable bonds: decrease in expected yield volatility
Event risk
Natural disaster
take over/corporate restructuring
regulatory change
Forms of sovereign risk
Unwillingness of the government to pay
inability to pay due to unfavorable economic conditions
What causes credit spread to widen
Worsening credit cycle
Weak macroeconomic climate
Decline in financial climate
Lack of market makers (brokers-dealers)
Insufficient demand for bond issue
Credit downgrades
Falling liquidity
