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Risk Associated with Investing in

Bonds

Pratik Bhagat

PGDMG13054

IFIM B School3/14/2014 1

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Risk Associated with Investing in Bonds

Interest rate risk

Yield curve risk

Reinvestment risk

Credit risk

Liquidity risk

Exchange rate risk

Volatility risk

Event risk

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Interest Rate Risk

The price of the bond changes in the opposite

direction to the change in interest rates or yield

Interest Rate 1

Bond Price

Interest Rate

Bond Price

Interest Rate

Bond Price

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Example

Risk that an investor faces is that the price of a bond

will decline if market interest rates rise. This risk

referred to as interest rate risk

Yield Price % Change

6% 100

6.50% 94.4479 5.55%

5.50% 106.0195 6.02%

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Measuring Interest Rate Risk

Yield Price

%

Change

%

change/bp

Avg (%

change/bp)

For

100bp

6% 906.25% 88 2.22% 0.0889% 0.1045% 10.44%

5.75% 92.7 3% 0.1200%

Approximate % price change for a 100bp change in yield is

( ) ( )

. .

() (. ) = .

Estimation of % price change for a 100bp is called Duration . So

duration is a measure of the price sensitivity of a bond to a change in

yield

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Yield Curve Risk

The graphical relationship between the yield

and maturity is called yield curve.

One of the factors that will affect how

sensitive a bondsprice is to change in yield is

thebonds

maturity.

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Parallel Shift in Yield Curve

maturity Original yield (%) maturity New Yield

2 5 2 5.25

5 5.25 5 5.5

20 5.5 20 5.75

30 5.75 30 6

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5

5.2

5.4

5.6

5.8

6

6.2

0 5 10 15 20 25 30 35

original yeild(%)

maturity

Power (original

yeild(%))Power (maturity)

Flattening of the Yield

curve

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Non-Parallel Shift in Yield Curve

maturity Original Yield (%) maturity New Yield (%)

2 5 2 5.05

5 5.25 5 5.4

20 5.5 20 5.75

30 5.75 30 6.1

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5.8

0 5 10 15 20 25 30 35

original yeild(%)

maturity

Power (maturity)

Power (maturity)

Steepening of theYield curve

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Risk

When the yield curve shifts, the price of the bond,

which was initially priced based on the initial yield

curve, will change in price. If the yield curve flattens,

then the yield spread between long- and short-term

interest rates narrows, and the price of the bond will

change accordingly.

If the yield curve steepens, this means that the

spread between long- and short-term interest rates

increases. Therefore, long-term bond prices willdecrease relative to short-term bonds.

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