interest rates increase => bond price decreases
interest rates decrease=> bond price increases
coupon rate = yield => price = par
coupon rate > yield => price > par
coupon rate < yield => price < par
The longer the bond's maturity, the greater the bond's price sensitivity to changes in interest rates.
The lower the coupon rate, the greater the bond's price sensitivity to changes in interest rates.
The value of a bond with embedded options will change depending on how the value of the embedded options changes when interest rates change.
A decline in interest rates will result in an increase in the price of callable bond but not by as much as the price change of an otherwise comparable option-free bond.
Duration is a measure of the price sensitivity of a bond to a change in yield.
=(Price if yield decline - Price if yield rise) / (2 * Initial price * Change in yield in decimal)
Duration is approximately equal to the point in years where the investor receives half of the present value of the bond's cash flows.
Correct?:
The dollar change in price is approximately equal to the product of the duration and the current value of the bond divided by 100.
Incorrect:
If a bond has an effective duration of 7.5, it means that a 1% change in rates will result in a 7.5% change in price.
Because of convexity, it will be approximately a 7.5% change in price, not an actual 7.5% change in price.
Disadvantages of call division:
1. The cash flow pattern is not known with certainty.
2. The investor is exposed to reinvestment risk if the interest rates are lower.
3. The price appreciation potential will be reduced.
Call risk is composed of three components: the unpredictability of the cash flows, the compression of the bond’s price, and the high probability that when the bond is called the investor will be faced with less attractive investment opportunities.
Amortizing securities makes reinvestment risk greater.
Zero coupon bond may be attractive to certain investors because there is no reinvestment risk, but on the other hand, it exposes to greater interest rate risk.
Credit risk includes:
1. Default risk: the issuer will fail to satisfy the terms of the obligation.
2. Credit spread risk:
The yield on a bond is made up of 2 components: the yield on a similar risk-free bond and a premium above the yield on a default-free bond necessary to compensate for the risks associated with the bond. The risk premium is referred to as a yield spread.
The part of the risk premium or yield spread attributable to default risk is called the credit spread. If credit spread widen, the market price of the bond will decline.
The yield differential above the return on a benchmark security measures the credit spread risk. Credit spread risk is also known as the risk premium or spread.
3. Downgrade risk:
Triple A: prime grade
Double A: high quality grade
Single A: upper medium grade
Triple B: lower medium grade
Lower-rated: speculative grade
Investment grade bonds: AAA, AA, A, and BBB
Non-investment grade bonds ( speculative/high yield ): Below BBB
Liquidity Risk: the risk that the investor will have to sell a bond below its indicated value, where the indication is revealed by a recent transaction. The wider the bid-ask spread, the greater the liquidity risk.
Price of callable bond = price of option-free bond - price of embedded call option
Price of putable bond = price of option-free bond + price of embedded put option
If expected yield volatility increases, the price of the embedded call, or put, option will increase.
Price compression reduces the potential for price appreciation.
When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price, even if interest rates fall considerably. It is unlikely that investors would pay a price that exceeds the call price.
All else equal, reinvestment risk and price risk move in opposite directions. For example, when interest rates rise, bond prices decrease, but the loss is at least partially offset by decreased reinvestment risk (it is less likely that a bond will be called and bondholders can invest coupon payments at higher yields). When interest rates fall, price risk decreases because the bond value is rising and reinvestment risk increases because it is more likely that the issuer/borrower will call the security and the bondholder must reinvest coupon payments at lower yields.
Technical default usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal.
Sovereign risk: the risk that as a result of actions of the foreign government, there may be either a default or an adverse price change even in the absence of a default.
1. Unwillingness of a foreign gov't to pay.
2. The inability to pay due to unfavorable economic conditions in the country.
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