Portfolio Risks and Returns - Bond Risks and Duration


Types of Risk

While more publicity is given to risk in the stock markets, there are a number of risks associated with investing in bonds:

  • Call risk - when interest rates fall, a callable bond is more likely to be called in; the investor would then have to replace it with a lower-coupon bond.

  • Reinvestment risk - this can refer to reinvestment of principal after a bond is called, as well as reinvestment of the dividends from a high-coupon bond into a lower-rate investment.

  • Credit risk - this refers to the possibility that the bond issuer will not be able to make expected interest rate payments and/or principal repayment.

  • Interest rate risk - if interest rates rise, the market value of the bond will decline. This is less of an issue if the investor can hold the bond until it matures.

  • Purchasing power risk - also referred to as inflation risk, this refers to the very real possibility that as inflation increases the purchasing power of the bond income will decrease.

  • Liquidity risk - this refers to the marketability of the bond. Certain issuers may be less marketable than others.

  • Event risk - any number of events can impact the creditworthiness of the issuer. Leveraged buyouts, corporate restructurings, mergers and acquisitions, and bankruptcies can all have a negative impact on a bond's price.

  • Opportunity risk - this refers to the potentially higher rate of return an investor could earn if the money used to purchase a bond were placed in an alternate investment.

  • Currency risk - also known as exchange risk, this was discussed in section 12 and applies only to foreign bonds.

Duration
The primary measure of bond price volatility is duration. It takes into account both the length of time to maturity and the difference between the coupon rate and the yield to maturity. Here are some of the most important facts about duration:

  • The longer the duration of a particular bond, the more its price will fluctuate in response to interest rate changes.

  • Duration is always equal to or less than the years to maturity of the bond.

  • Duration can help to calculate the impact of interest rate changes on the price of the bond. For example, a bond with a duration of 8 is likely to decrease 8% for every100-basis-point increase in market interest rates.

  • Duration is a weighted average term to maturity.

  • As payment frequency increases, duration decreases.


Look Out!
A zero-coupon bond, with only one payment (at the end of the term), has the highest duration of any bond and is therefore the most sensitive to price changes due to interest rate changes. You are very likely to be tested on this on the Series 65 exam.

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