BOND RISKS

<< Accrued Interest

UNDERSTANDING RISK AND RETURN >>

Investment Analysis & Portfolio Management (FIN630)

The buyer of a bond must pay the accrued interest to the seller of the bond. Similarly, the

bond seller receives accrued interest from the new bond owner- One day's interest accrues

for each day the bond exists. The owner of the bond is entitled to it even though it might not

be distributed for several more months. The price of a bond including the accrued interest is

known as the dirty price. The price without accrued interest is the clean price. By

convention in (lie United States, we compute the accrued interest on corporate and

municipal bonds using a 360-day year (12 months of 30 days each) and do not count the

transaction settlement date in the total. With Treasury securities, we use the actual number

of days.

At the end of the calendar year, bond investors must report the interest they earned to the

Internal Revenue Service. Interest income from bonds equals the interest checks received

plus accrued interest received minus accrued interest paid.

BOND RISKS:

Statements Such as "stock is risky, bonds arc not," are not accurate. Bonds do carry risk,

although the nature of their risk; is different from that of an equity security. To properly

manage a group of bonds, an investor must understand the types of -risk they bear.

Price Risks:

The price of a bond can change ever)' day as the "net chg" column in Figure 4-2 indicates.

The two components of price risk are default risk and interest rate risk.

Default Risk:

The possibility that a firm will be unable to pay the principal and interest on a bond in

accordance with the bond indenture is known as the default risk. Standard & Poor's and

Moody's are the two leading advisor)' services reporting on the default risk of individual

bond issues. Standard & Poor's gives bonds a rating based on a scale of AAA (least risk) to

D (bonds in default). The ratings from AA to CCC may carry a plus or minus. Table 4-5

shows the complete set of ratings. An investment grade bond is rated BBB or higher; any

bond with a lower rating is known as a junk bond. .Many fiduciaries are limited by law to

bonds that are investment grade.

Some bonds originate with an investment grade, but are later downgraded below BBB. Such

a bond is a fallen angel. Salomon Brothers uses the term zombie bond to refer to a highly

speculative bond, once thought long dead, that shows signs of life by a price run-up.

Standard & Poor's has a separate description for each of the ratings AAA, AA, A, and BBB.

Junk bonds, however, are all covered by a single definition, the salient portion of which

states that these bonds are regarded on balance, as predominately speculative with respect to

capacity to pay interest and repay principal in accordance with the terms of the obligation.

Interest Rate Risk:

Bonds also carry interest rate risk, which is the chance of loss because of changing interest

rates. If someone buys a bond with a 10.4% yield to maturity and market interest rates rise a

week later, the market price of this bond will fall. It would fall because risk-averse investors

will always prefer a higher yield for a given level of risk. Newly issued, equally risky bonds

will yield more after the interest rate rise, and investors will only be willing to purchase the

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Investment Analysis & Portfolio Management (FIN630)

old bonds if their price is reduced. Relative to the purchase price, a bondholder has a paper

loss after the rise in interest rates. If the bonds were to be sold at this point, there would be a

realized loss.

Suppose in December 1999 an investor buys a newly issued, 7% coupon, 15-year bond at

par. Because the bond is purchased at par, its yield to maturity equals the coupon rate of

7%. At the purchase date, the valuation equation is as follows:

Po=∑ $35.00/(1+.07/2)t + $1000/(1+.07/2)30 =$1000

One year later (December 2000) bonds of similar risk yield 6.5%. The decline in interest

rates will cause our investor's bond to appreciate. Its new price should be

Po=∑ $35.00/(1+.065/2)t + $1000/(1+.065/2)28 =$1045.5

The principal value of the bond appreciated by 4.55% from the purchase price, plus the

bondholder received $70 in interest over the year. If the bond were sold at this point, the

investor's holding period return would be:

(1045.51-1000+70)/1000 = 11.55%

which is substantially greater than the anticipated 7% yield to maturity. Note that if the

investor does not sell at this point, choosing instead to keep the bond until its maturity, the

bond price will eventually converge on the $1,000 par value.

Suppose that two years later, in December 2002, interest rates have gone up to 8%. The

bond price will necessarily come down:

Po=∑ $35.00/(1+.08/2)t + $1000/(1+.08/2)24 =$923.77

These changing values illustrate the nature of interest rate risk: changing interest rates will

change the market value of a bond investment. While it is true that investors who hold

bonds until maturity almost always get their investment back, they can never know for

certain what path the price will take as it moves toward its maturity date.

Convenience Risks:

Convenience risks comprise another category of risk associated with bond investments.

These risks may not be easily measured in dollars and cents, but they still have a cost.

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