Bond Risks

Interest Rate Risk

Interest rate risk is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond’s duration, a technique used to manage interest rate risk exposure.

There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:

1.      Marking to market, calculating the net market value of the assets and liabilities.

2.      Stress testing the market value by shifting the yield curve in a specific way. Duration is a stress test where the yield curve shift is parallel.

3.      Calculating the Value at Risk (VaR) of the portfolio.

4.      Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves.

5.      Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.

Credit Risk

Credit risk is the risk of loss due to a debtor’s non-payment of a loan or other line of credit, either the principal or interest or both. The higher the perceived risk the more spread over a risk free rate will be required. A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow users to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes and in return, it agrees to buy the debt at the defaulted market price, should a credit event (“default”) occur.

Liquidity Risk

Liquidity risk arises from situations in which a party interested in trading an asset cannot do so because there is no counterparty willing to purchase the asset. Liquidity risk becomes significant during times of market distress, since it affects the ability to execute trades with immediacy, depth and resilience.

This risk is very different from a significant drop in price. A fall to a price of zero is saying that the asset is worthless. Liquidity risk is usually found more often in emerging markets or low-volume markets. Liquidity is one of the most unstable and difficult to measure risk parameters.

Bonds Issued by Foreign Entities

Many non-domiciled issuers may target foreign currency markets either to access alternative global investment capital or those markets that may appear to be more stable and predictable than their domestic currency. Note that foreign issuance is subject to strict local banking regulations.

The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company’s local currency to be used for existing operations. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. The table below lists some of the generic issuance “labels”:

Eurobond	A bond issued outside the issuer’s domestic market and jurisdiction
Eurodollar	USD bond issued by a non-US entity outside the US
Yankee	USD bond issued by a non-US entity in the local market
Maple	CAD bond issued by a non-Canadian entity in the local market
Samurai	JPY bond issued by a non-Japanese entity in the local market
Shogun	Non-JPY bond issued by a non-Japanese entity in the local market
Kangaroo	An AUD bond issued by a non-Australian entity in the local market
Panda	A Chinese renminbi bond issued by a non-Chinese entity in the Peoples Republic of China
Matrioshka	RUB bond issued by a non-Russian entity in the local market
Kimchi	Non-KWR bond issued by a non-Korean entity in the local market

Types of Bonds

Fixed rate bonds have a coupon that remains constant throughout the life of the bond. These bonds are therefore sensitive to the general interest rate environment, and as rates rise the bonds lose value. Floating Rate Notes (FRNs or floaters) pay a coupon that is linked to a money market index, such as LIBOR or EURIBOR, e.g. three-month USD LIBOR + 0.50%. Since the coupon is reset periodically, typically every three months, these bonds are generally insensitive to interest rate movements.

Zero-coupon bonds pay no interim interest. All interest is compounded at the initial internal rate of return and paid out as a lump sum at maturity. As such, they trade at a discount to par value. The main benefit for investors of zero-coupon bonds is the elimination of coupon reinvestment risk. Issuers have the advantage of delaying the interest cash outlay until maturity. However, from a credit risk viewpoint, zero-coupon bonds have more risk as investors have to wait until maturity to receive any income.

High yield bonds are bonds that are rated below investment grade by the credit rating agencies (see section on credit ratings). As these bonds are relatively risky, investors expect to earn a higher yield. These bonds are also called junk bonds or speculative grade securities. High yield bonds tend to be relatively illiquid and are also highly sensitive to the credit quality of the issuer (volatile credit spread that is priced into the bond value expressing the market implied default risk).

Subordinated bonds are those that have a lower priority (than other bonds of the same issuer) in terms of claims over the corporate assets in cases of liquidation. The order in which recovery values are allocated after a default follows what is referred to as the priority of payment, more commonly known as the “waterfall”. Since subordinated bond holders are paid after senior obligations, the risk is higher. Consequently, they have lower credit ratings than obligations higher up the capital structure.

Inflation-linked bonds, in which both the principal amount and the coupon payments are indexed to inflation, offer real rates of return. Therefore, the initial coupon is lower than comparable conventional bonds of the same maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation-linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation-linked bonds issued by the US government. The largest inflation bond market in the Eurozone is in France.

Asset-Backed Securities (ABS) are bonds whose interest and principal payments are backed by cash flow receivables from a pool of underlying assets. Examples of asset-backed securities are Mortgage-Backed Securities (MBSs), Collateralised Mortgage Obligations (CMOs) and Collateralised Debt Obligations (CDOs).

Municipal bonds are securities issued by a state, city, local government, or their agencies primarily in the US. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, subject to local jurisdiction. 

Debt Securities & Bond Characteristics

Debt Securities

A bond is a debt obligation contracted by an issuer/borrower, where the issuer is obliged to make regular payments of both interest and principal. Compared with loans, there is a much more active secondary market and bonds can be sold without requiring the approval of the borrower.

Bond Characteristics

Bonds have the following attributes:

• They generally do not have flexible payment structures. The bond indenture, specifying the rights of bond holders, generally requires approval by a majority (substantial) vote before amendments can be made to the documents
• Their issuance requires some form of public disclosure (the amount of information depends on the market used for issuance)
• Bonds are much easier to sell to investors when they have a credit rating
• The maturity of bonds can be much longer than for bank loans. For example, bank loans are rarely longer than seven years (perhaps beyond ten years for property loans), whereas bonds can be issued with maturities of thirty years and beyond. There are three groups of bond maturities: short term (bills) for maturities up to one year; medium term (notes) for maturities between one and ten years, and long term (bonds) for maturities greater than ten years
• Bonds can be issued paying either fixed or floating interest. Floating rate bonds are called FRNs (Floating Rate Notes). Each year, the amounts of fixed or floating bonds issued vary according to the inclinations of issuers and investors. In the US, most bonds pay a coupon on a semi-annual basis while in Europe, most bonds are annual and pay only one coupon a year. It is also worth noting that each currency market assumes a different day count convention when calculating the accrued interest payable for each coupon (actual/360, actual/365, 30/360 or actual/actual)
• Bonds are less likely to have restrictive covenants. However, in recent years, investors have been able to achieve more protection, particularly the change of control covenant
• Some bonds may contain embedded optionality that grants either the holder or the issuer certain predefined rights. Callable bonds give the issuer the right to repay the principal before the scheduled maturity date on specified call dates at a price typically around the bond’s par value. Such structures are frequently used in the US agency and high yield markets. Puttable bonds offer holders the right to force the issuer to repay the bond before the maturity date on the specified put dates; offering investors extra protection against declining creditworthiness.