Key Takeaways
- Interest rate risk: bond prices fall when rates rise — long-term bonds have MORE interest rate risk
- Credit (default) risk: the issuer may fail to make interest or principal payments — mitigated by higher ratings
- Reinvestment risk: when interest rates fall, coupons must be reinvested at lower rates — affects short-term bonds more
- Duration measures a bond's price sensitivity to interest rate changes — higher duration = more sensitivity
- Zero-coupon bonds have the highest duration (equal to maturity) and NO reinvestment risk
Bond Risks and Duration
Understanding bond risks is essential for making suitable investment recommendations. Different investors have different risk tolerances and time horizons, requiring careful matching of bond characteristics to client needs.
Types of Bond Risk
Interest Rate Risk
Interest rate risk is the risk that bond prices will fall when interest rates rise.
| Factor | Effect on Interest Rate Risk |
|---|---|
| Longer maturity | More interest rate risk |
| Lower coupon | More interest rate risk |
| Zero coupon | Highest interest rate risk |
Why Long-Term Bonds Are Riskier: When rates rise, you're locked into a below-market rate for a longer time, so the price must fall more to compensate buyers.
Credit (Default) Risk
Credit risk is the risk that the issuer will fail to make interest payments or return principal.
| Issuer Type | Credit Risk Level |
|---|---|
| U.S. Treasuries | None (risk-free) |
| Investment Grade Corporate | Low to moderate |
| High Yield (Junk) Corporate | High |
| Municipal | Generally low |
Mitigation: Buy higher-rated bonds, diversify across issuers.
Reinvestment Risk
Reinvestment risk is the risk that when coupons are received (or the bond matures), interest rates will be lower, forcing reinvestment at lower rates.
| Factor | Effect on Reinvestment Risk |
|---|---|
| Shorter maturity | More reinvestment risk |
| Higher coupon | More reinvestment risk |
| Zero coupon | NO reinvestment risk |
Why Zero-Coupon Bonds Have No Reinvestment Risk: There are no coupons to reinvest — you simply hold the bond to maturity.
Interest Rate Risk vs. Reinvestment Risk
These two risks work in opposite directions:
| Risk Type | When It Hurts | Affects Most |
|---|---|---|
| Interest Rate Risk | Rates rise | Long-term bonds |
| Reinvestment Risk | Rates fall | Short-term bonds |
Important: A bondholder cannot eliminate both risks simultaneously (except with zero-coupon bonds held to maturity).
Other Bond Risks
| Risk | Description | Mitigation |
|---|---|---|
| Inflation Risk | Purchasing power erodes | TIPS, I-Bonds |
| Call Risk | Issuer redeems early when rates fall | Buy non-callable bonds |
| Liquidity Risk | Cannot sell easily at fair price | Buy actively traded issues |
| Currency Risk | Foreign bond value changes | Hedge or avoid |
Duration
Duration measures how sensitive a bond's price is to changes in interest rates. It tells you approximately how much a bond's price will change when rates change.
What Duration Tells You
- Duration is expressed in years
- Higher duration = greater price sensitivity
- It represents the weighted-average time to receive all cash flows
Approximate Price Change Formula
Price Change ≈ -Duration × Change in Interest Rates
Example: A bond with duration of 6 years would:
- Fall approximately 6% if rates rise by 1%
- Rise approximately 6% if rates fall by 1%
Factors Affecting Duration
| Factor | Effect on Duration |
|---|---|
| Longer maturity | Increases duration |
| Lower coupon | Increases duration |
| Lower yield | Increases duration |
| Zero coupon | Duration = Maturity |
Duration by Bond Type
| Bond Type | Relative Duration |
|---|---|
| Zero-coupon (long-term) | Highest |
| Low-coupon, long-term | High |
| High-coupon, short-term | Low |
| Floating-rate bonds | Lowest |
Managing Interest Rate Risk with Duration
Duration Matching
Investment advisers may match portfolio duration to the client's investment horizon to minimize interest rate risk.
Example: If a client needs funds in 7 years, a bond with 7-year duration would be appropriate.
Bond Ladder Strategy
Creating a "ladder" of bonds with staggered maturities reduces both interest rate risk and reinvestment risk:
- Some bonds mature when rates are high (good reinvestment)
- Some bonds mature when rates are low (locks in prior rates)
Exam Tip: Know the factors that increase duration (longer maturity, lower coupon, lower yield). Zero-coupon bonds have duration equal to their maturity. Duration allows you to estimate price changes: if duration is 5 and rates rise 1%, the price falls approximately 5%.
Which bond would have the HIGHEST duration?
Zero-coupon bonds have NO:
A bond has a duration of 7 years. If interest rates rise by 1%, the bond's price will approximately:
Which risk increases with SHORTER bond maturities?
3.1 Common Stock
Chapter 3: Equity Securities