Bond risks and characteristics are crucial aspects of fixed-income investing. Understanding these elements helps investors navigate the complexities of the bond market and make informed decisions about their portfolios.

This section covers key bond risks, including interest rate and default risk. It also explores duration as a measure of interest rate sensitivity, factors affecting default risk, and strategies like bond laddering to manage risk. Additionally, it delves into credit ratings, yield to maturity calculations, and other important bond-related concepts.

Bond Risks and Characteristics

Key bond risks

• Interest rate risk involves the potential for bond prices to change due to fluctuations in market interest rates
  • Bond prices and market interest rates have an inverse relationship
    • Rising market interest rates cause bond prices to decline
    • Falling market interest rates lead to an increase in bond prices
  • The yield curve illustrates the relationship between interest rates and bond maturities
• Default risk, also referred to as credit risk, is the possibility that a bond issuer may not fulfill their obligation to make scheduled interest or principal payments
  • Failure to meet these payments results in a default on the bond

Duration for interest rate risk

• Duration quantifies a bond's sensitivity to changes in market interest rates and is expressed in years
  • Represents the weighted average time required to receive a bond's cash flows
• Macaulay duration is calculated using the formula: $\frac{\sum_{t=1}^{n} \frac{C_t}{(1+y)^t} \times t}{\sum_{t=1}^{n} \frac{C_t}{(1+y)^t}}$
  • $C_t$ denotes the cash flow received at time $t$
  • $y$ represents the yield to maturity
  • $n$ is the number of periods until the bond matures
• Modified duration is derived from Macaulay duration using the formula: $\frac{Macaulay\ Duration}{1 + y}$
  • Measures the percentage change in a bond's price given a 1% change in yield
• Bonds with longer durations exhibit greater sensitivity to interest rate changes and thus carry higher interest rate risk
• Convexity measures the rate of change in a bond's duration as interest rates fluctuate

Factors in bond default risk

• Issuer's creditworthiness assesses their financial stability and ability to generate sufficient cash flows to service their debt obligations
• Bond's seniority determines the priority of repayment in the event of default, with senior debt taking precedence over subordinated debt
• Collateral backing a bond can reduce default risk, as secured bonds are backed by specific assets, while unsecured bonds lack this protection
• Bond covenants impose restrictions on the issuer's activities to safeguard the interests of bondholders
• Macroeconomic conditions, such as economic recessions, can increase default risk across all bond issuers

Bond laddering strategy

• Bond laddering is a strategy that involves constructing a portfolio of bonds with varying maturities
• Helps to diversify interest rate risk by allocating investments across different maturity dates
• As shorter-term bonds mature, the proceeds are reinvested in longer-term bonds
• Provides a consistent stream of cash flows and mitigates the impact of interest rate fluctuations on the overall portfolio

Credit ratings for default risk

• Credit rating agencies, such as Moody's, Standard & Poor's, and Fitch, evaluate the creditworthiness of bond issuers
• Ratings span from AAA (highest quality) to C or D (default)
  • Investment-grade bonds are rated BBB (S&P) or Baa (Moody's) and above
  • High-yield or "junk" bonds are rated below BBB (S&P) or Baa (Moody's)
• Lower credit ratings signify higher default risk and generally offer higher yields to compensate investors for the increased risk

Yield to maturity calculation

• Yield to maturity (YTM) represents the total return earned by holding a bond until it matures
  • Assumes all cash flows are reinvested at the same rate as the YTM
• YTM is calculated using the bond's current market price, face value, coupon rate, and remaining time to maturity
• YTM is the discount rate that equates the present value of a bond's future cash flows to its current market price
• The formula for calculating YTM is: $Bond\ Price = \sum_{t=1}^{n} \frac{C_t}{(1+YTM)^t} + \frac{Face\ Value}{(1+YTM)^n}$
  • YTM is determined through trial and error or by using a financial calculator
• A higher YTM indicates a higher expected return and typically implies higher risk associated with the bond

Additional Bond Risks

• Liquidity risk: The potential difficulty in selling a bond quickly without incurring significant losses
• Reinvestment risk: The possibility that future cash flows from a bond will be reinvested at a lower interest rate
• Call risk: The risk that an issuer will redeem a callable bond before its maturity date, potentially forcing investors to reinvest at lower rates
• Inflation risk: The potential for the purchasing power of bond interest payments and principal to decrease due to rising inflation