- Types of Bonds | Boundless Finance
- Consider Premium Bonds To Counter Interest Rate Risk
- Interest Rate Risk
A real-world example can be found in the bonds of R. We are not commenting on the credit quality of RRD bonds or offering an opinion - the point is to illustrate real-world pricing comparisons of bonds. The chart compares three bond issues based on prices offered at the time of this writing. As can be seen, the bond with the 8. Two other bond issues maturing in and , years later than the bond, have YTMs that are significantly lower.
Why is this the case, when longer-dated bonds should offer higher returns? But in return for this higher price, an investor enjoys a much higher interest rate, in this case 8. The actual economics of the bond shows that an investor should not care that the bonds trades at this premium price.
In conclusion, when building a bond portfolio in today's market, paying close attention to duration is critical, given the strong possibility of rising rates. While we believe the threat of rising rates to corporate bonds is overblown dire warnings about this threat are now five years old , especially in regards to high-yield bonds which the data shows are not closely tied to movements in interest rates , it still is a risk that needs to be considered.
Types of Bonds | Boundless Finance
The key way to mitigate this risk is to focus on shorter-duration bonds, and one way to meet this goal is to include a mix of premium bonds. All Rights Reserved. Your use of this service is subject to our Terms of Use and Privacy Policy. Information is provided 'as is' and solely for informational purposes, not for investment purposes or advice.
Consider Premium Bonds To Counter Interest Rate Risk Many investors shun premium bonds, believing that it is a mistake to pay more than face value for a bond. Ans : B ; B is correct because the bond would sell below par or at a discount if the yield required by the market rises above the coupon rate. Ans : A ; Since both securities have essentially the same maturity, all else the same, the bond with the lower coupon rate will have a higher sensitivity to changes in interest rates.
When interest rates fall, the price of a callable bond will : A. Ans : B ; The call feature limits the upside price movement of a bond when interest rates fall. If market interest rates rise, the price of a callable bond, compared to an otherwise identical option-free bond, will most likely decrease by: A. Ans : B ; B is correct.
Consider Premium Bonds To Counter Interest Rate Risk
Duration is most accurate as a measure of interest rate risk for a bond portfolio when the slope of t he yield curve: A. Ans : C ; C is correct because duration assumes that yields change by the same amount across all maturities. Based on these estimates, the duration of the bond is closest : A. The dollar duration of the bond is closest to : A. Compared with an otherwise identical amortizing security, a zero-coupon bond will most likely have : A. Ans : B ; Less reinvestment risk : An amortizing security is exposed to reinvestment risk since it receives periodic payments of both interest and principal that must be reinvested ; while a zero-coupon bond has no reinvestment risk since no cash flows are received that must be reinvested before maturity.
The reinvestment risk for an investor holding the bonds to maturity is greatest for the bond that is : A. Ans : C ; Reinvestment risk refers to the risk that interest rates will decline causing the future income expected from reinvesting coupon payments to decline. Ans : C ; A is not correct. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely : A.
Ans : C ; Credit spread risk is correct since the bond is expected to see a widening of spreads as a result of deteriorating fundamentals and a potential downgrade but still remaining investment grade. What risk does the bid-ask spread most closely measure : A. Liquidity risk. Credit spread risk. Inflation risk. Ans : A ; A is correct. All else equal , an increase in expected yield volatility is most likely to cause the price of a : A. Ans : B ; An increase in expected yield volatility increases the values of both put options and call options.
A portfolio of option-free bonds is least likely to be exposed to : A. Exercise Problems:. Bond A. Bond B. Oct 29, Nov 5, Ans : B ; Volatility risk is present for fixed-income securities that have embedded options. Fortunately, you don't need a math degree to understand the basic concepts. Here are some simple guidelines for judging the price volatility of your bonds. The price that a bond sells for in the market today is the sum of all future cash flows, discounted in value because they are not available today. A dollar tomorrow is worth less to you than a dollar today.
The discount rate used is the rate of interest prevailing in the market for bonds of the same risk and maturity. When that interest rate changes, it affects the price of all bonds, but to varying degrees. The reason is that the maturity value of the long-term bond, as well as many of the interest payments that are being paid, are future cash flows that are very distant points in the future. If interest rates rise, those very distant cash flows of the long-term bond are discounted in value significantly, and the price of the long-term bond falls in the market abruptly.
Interest Rate Risk
Coupon rates—the periodic interest payment that is paid by the issuer of the bond—also affect bond price volatility. A higher coupon means that more cash in the form of interest payments flows to the investor before maturity than is the case with a lower coupon bond. What this means is that when interest rates rise and future cash flows are discounted at a higher rate, the lower coupon bond has relatively more cash flow in the distant future, the maturity value of the bond represents a greater portion of the total cash flow, and the bond's value today will fall relatively more. Combining these characteristics produces the riskiest bonds in terms of price volatility: The most price volatile bonds are those with longer maturities and lower coupons.
A long-term zero-coupon bond defines the outer boundary for riskiness.
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- Relationship between Coupon Rate and Interest Rate Risk!
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Investors who are risk averse should look for bonds and bond mutual funds that have shorter average maturities—less than five years—and should avoid zero-coupon bonds, particularly long-term zero-coupon bonds. Table 1 indicates just how much bond prices can change when interest rates change. The table shows the percentage change in bond price for a given interest rate change for bonds of different maturities and two different coupon rates.
The table is based on the assumption of semiannual interest payments and bonds selling at their maturity face value. Because of the mathematics of the relative change, the gains are always larger than the losses for the same interest rate change. Both of these interest rate changes are a bit on the high side but not impossible, and the gains and losses are large because the bond maturity is so long. You can see from the table that the lower-coupon bond at the same maturity has greater price volatility.
A higher coupon rate for the same maturity would result in smaller but still very significant price changes.