The risks embedded in bonds

Sometimes the smallest source of risk can expand to cause catastrophic losses when stress periods arrive.

  • Wiley Global Finance WILEY GLOBAL FINANCE
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Bonds can be thought of as a package of fixed cash flows for a certain period of time and then repayment of initial principal. In financial settings, it is generally equally, if not more, constructive to think of securities and contracts as packages of risks rather than just as cash flows. These risks can range from the mundane to minute hidden ones, and each deserves time and management—sometimes the smallest source of risk can expand to cause catastrophic losses when stress periods arrive. Any fixed income instrument can also be decomposed into a set of standard types of risk exposure. For any given instrument, some risks may be especially important. Other instruments may exist solely to offset certain classes of risks. These classes of risks include:

  • Interest rate risk
  • Credit risk
  • Inflation risk
  • Financing/liquidity risk
  • Tax risk
  • Regulatory risk

Interest rate risk

This is perhaps the starting point when considering the risk embedded in any fixed income instrument. Any security—such as a bond, loan, or any other contract with fixed cash flows over a certain period of time—is exposed to interest rate risk. Interest rate risk stems from fixed cash flows being received or paid, and therefore, changes in the broader market interest rates can make these fixed cash flows seem more or less attractive. As this attractiveness changes, so does the price of the security. For example, if a trader buys a bond paying a fixed 5% interest payment and, immediately following this purchase, prevailing interest rates for similar instruments in the market rise to 8%, the 5% bond suddenly looks like a poor investment. If the trader tried to resell the 5% bond, other traders would demand a discount to accept a 5% rate when they can buy similar instruments paying 8%. This reasoning can explain why the 5% bond would gain in value if interest rates on similar instruments fell to 3%.

This example demonstrates why a fixed-rate bond, or any other fixed-rate instrument, is sensitive to interest rates. Notice the disclaimer about "similar instruments" in the last example. The interest rate that the fixed-rate bond is sensitive to is always the rate being offered in the market on similar instruments. For example, a 10-year US corporate bond will not be sensitive to changes in rates offered by 5-year Korean government bonds unless such changes affect rates of other 10-year US corporate bonds. In the financial world, though, interest rates are highly correlated, making it crucial to track global flows and developments to effectively manage the interest rate risk. The degree to which a bond is sensitive to interest rate risk is known as duration, which is discussed later.

Finally, there are types of fixed income securities that do not face much interest rate risk. Such securities are known as floating rate bonds. These bonds, instead of paying a fixed cash flow, make coupon payments that are linked to some short-term interest rate that resets at a frequent interval. This way, as interest rates rise or fall the cash flows of the bond itself change to mirror the interest rate changes.

Credit risk

In the pricing calculations discussed regarding bonds, there is an implicit assumption of timely coupon payments and repayment of principal. If this were not the case, the bond price could differ significantly from the simple calculation, especially if repayment of principal appears to be in doubt. Such risks are known as credit risks and stem from the issuer's possible inability to finance the issued debt. In such bonds, the pricing calculations become significantly more complex as probabilities need to be assigned to the bond payments in different scenarios. Note that even in the case of default—that is, if the issuer cannot repay the principal—the bond may have value since the assets of the issuer would be sold off to pay some recovery amount to the bond holders.

Certain types of fixed income instruments do not have any significant credit risk associated with them. The instruments discussed are mostly US government credit risk, in either a direct or an indirect way, which generally have less credit risk. Other types of bonds, such as corporate bonds or derivatives contracts with banks, can have a different source of credit risk associated with them. Credit risk can grow for even top-quality issuers; after all, Lehman Brothers debt was highly rated, until it was not.

Even the US government—which is often considered risk free from a credit risk standpoint—may not enjoy that status in the future. However, for an investor or trader attempting to value and trade government bonds, the credit risk of the US government is not likely to have any meaningful impact on the price today. Credit risks are a dominant form of risk for fixed income markets, such as high-yield corporate debt issued by weaker corporate issuers, riskier emerging market debt, and subprime mortgage debt. Such markets are referred to, collectively and imprecisely, as credit markets. Even if the particular fixed income security being considered does not itself have credit risk, it is important to follow developments in the credit markets, as they are very sensitive to the economy and financial leverage. Perhaps the most glaring example of the importance of following these markets was the start of the credit crunch in 2007, which stemmed from cascading problems in the subprime mortgage markets.

Inflation risk

Inflation risk tends to affect bonds in a more subtle way by eroding the value of future cash flows. Even if an issuer's credit risk is almost negligible, such as the US Treasury's, the constant coupon payments on bonds could lose money if prices rise. As an extreme example, a fixed $5 coupon payment is only half as valuable if prices double instantly. Inflation risk especially grows as a concern for longer-term bonds as more coupon payments, not to mention the principal, are at the mercy of rising prices. Some issuers, especially in the sovereign category, such as the US government and other developed markets, do issue bonds whose valuations are linked to inflation and thus protect the buyer against erosion of cash flows in the future. For example, in US Treasury Inflation-Protected Securities, the principal itself grows at the inflation rate, thus greatly reducing inflation risk for the buyer. However, the sizes of these inflation-linked markets are mostly dwarfed by "nominal" instruments where the fixed payments are not adjusted for inflation. In general, for inflation protection, investors tend to look outside fixed income to products such as commodities and equities.

Financial/liquidity risk

Financing and liquidity are related classes of risk that are easy to ignore during good times. In times of ample financing capacity and asset price appreciation, it is generally easy to borrow money to magnify ownership of a security and earn outsized returns if prices indeed keep going up (a concept known as leverage). However, if the tide turns and lenders themselves incur stress, they are likely to call back loans made to purchase other securities, which leads to a cascading effect of forced selling and declining asset prices. An example of this phenomenon is a prospective homeowner buying a house. If the house is worth $100,000, the homeowner may receive a loan for $80,000 and use $20,000 of their own money as a down payment. This way a relatively small amount of money ($20,000) controls an asset worth a fair bit more ($100,000). Suppose the mortgage loan is of a short tenor, such that the bank has to reauthorize the loan every month as it wishes—this is not common for a house loan but is common in more complex financial transactions. As long as the economy and general market conditions remain steady, there tends to be little problem with this leverage, but if funds become scarce and the bank lending money for the house faces losses, it may call back the home loan. In that case, the homeowner would need to pay back the $100,000 borrowed with interest. If the homeowner is forced to sell the house to pay back the loan, house prices will fall. Although we use a house in the example for the sake of simplicity, trillions of dollars' worth of securities are bought and sold in the market using loans with very short tenors such as overnight or one week. In financial markets, as with housing, the capacity to borrow, known generally as liquidity, is key to maintaining stable prices.

Tax risk

Taxation is an inevitable part of life. As tax rates change, they may make certain securities more or less valuable. For most fixed income securities, the interest payments are taxable at the income tax rate, and changes in the value of the security taxable at the capital gains rate. For 2 securities facing similar taxation, the tax risk differential between the 2 is not relevant. However, the municipal bond market does face differential taxation from the rest of the taxable universe. For municipal bonds, the interest payments are tax-exempt from federal income tax. Given top federal income tax rates of around 35% to 40% today, this is a very valuable exemption. In general, tax risk is difficult to control for in most instruments, but the municipal bond market does offer tax-exempt instruments to at least mitigate some negative effects of taxation on returns.

Regulatory risk

The term "regulatory risk" covers a large set of risks related to changing regulations and other possibly arbitrary government action that can have a negative impact on returns. Regulatory risk is almost by definition impossible to fully neutralize. However, certain precautions can be taken. Awareness of possible upcoming changes in regulation and their effects on the particular securities held in a portfolio is of great importance. Regulatory risk came to the forefront during the credit crunch of 2007 to 2008, with numerous events reflecting the sometimes arbitrary actions of the government during stress periods. For example, after months of denials and pronouncements about the safety of Freddie Mac and Fannie Mae, the agencies eventually were taken under government conservatorship (i.e., quasi-nationalization) with a wide range of outcomes for various agency securities holders. Senior debt holders came out in relatively good shape; owners of preferred stock, previously a fairly safe instrument in the context of the agencies, lost almost all value. Even owners of derivatives contracts on these corporations faced considerable uncertainty regarding payout, given the unusual outcomes. The credit crisis of 2008 brought to the forefront the nature of such risks even in supposedly stable, developed markets, where government action could be just as erratic and unpredictable as that of any emerging market.

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