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Credit Risk in Bonds

The investors in a bond issue also face credit risk as they are actually lending money to the issuer. The credit risk can arise in three forms, namely, default risk, credit spread risk, and downgrade risk. Let’s look at each of them in detail. Default Risk This is the simplest form of credit risk and

Reinvestment Risk in Bonds

Investors in fixed income securities, such as bonds, face reinvestment risk. The risk arises from the fact that the investor may have to invest the interim cash flows from the bonds at a lower interest rate than what he earns from the security. For example, if the security has a yield-to-maturity (YTM) of 10%, this

Call and Prepayment Risk

A bond may have a call provision that allow the issuer to call the bond back before its maturity date. Since a call feature is a benefit to the issuer, its value is lower than a similar plain vanilla bond. The call provision brings three key disadvantages to the investor. The investor cannot be certain

Bond Duration and Convexity Simplified – Part 2 of 2

As we learnt in part 1, the duration, as measured by the slope of the curve, changes as yields change. The slope of the curve is steeper (and the duration is larger) at low yield levels, and becomes flatter (and the duration becomes smaller) at high yield levels. This property is called convexity. Convexity is

Bond Duration and Convexity Simplified – Part 1 of 2

While analyzing bonds, it is important to apply the concepts of duration and convexity. Duration has been an excellent tool to forecast the approximate price change of a bond or portfolio of bonds. However, with larger yield changes and securities with embedded options, duration becomes less accurate at estimating price changes. Duration can be combined

Interest Rate Risk of Floating-rate Bonds

In case of fixed-rate bonds, the coupon is set as a reference rate plus a margin. Since the reference rates changes periodically, the coupon rate for the bond is also reset periodically, such as monthly, quarterly, or every six months. Every time the coupon is reset, the bond’s price also resets to par. However, the

Price of a Callable Bond

The debt securities issued in the market can have many features; one such feature is an embedded option such as a call option. The call option gives the issuer the right to but the bond back from the investor at prespecified terms after a certain period. Similarly, there could be a put feature in the

Impact of Yield Level on Bond’s Price Sensitivity

In the previous article we learned about how maturity, coupon, and embedded options impact interest rate risk in bonds. Apart from this, the price sensitivity of a bond to interest rate change is also affected by the level of yield (interest rate). Note that other factors remaining the same, the different bonds trade at different

Bond Features Affecting Interest Rate Risk

We know that a bond’s price is inversely related to the yield. How sensitive a bond price is to yield depends on the various features of the bond such as its maturity, coupon rate, and any embedded options in the bond. Let’s look at how these factors influence the impact of interest rate changes on

Understanding Inverse Price/Yield Relationship in Bonds

The investors in bonds face interest rate risk because the price of the bond is inversely proportional to the changes in interest rates. So, if interest rates rise, the bond’s price will fall and if interest rates fall, bond’s price will rise. But why this inverse relationship? Let’s understand this with the help of an