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Banking Essentials - Part I

This pathway will walk us through the basics of banks, starting with some of the different types and their main functions, then starting to look at the regulation faced by the banks, both before and after the Global Financial Crisis.

Greenwashing

Greenwashing is the act of distributing false information about something being more environmentally friendly than it actually is.

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+1,000 expert presented, on-demand video modules

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Managed learning

Build, scale and manage your organisation’s learning

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Tackling the Cost of Living Crisis

In this video, Max discusses the cost-of-living crisis currently enveloping the UK. He examines its impact on households as well as the overall economy.

CSR and Sustainability in Financial Services

In the first video of this two-part video series, Elisa introduces us to sustainability. She begins by looking at the difference between sustainability and corporate social responsibility, two terms that can be easily confused.

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Risks Inherent in Bonds

Risks Inherent in Bonds

Lindsey Matthews

30 years: Risk management & derivatives trading

Many bond market commentators will use duration as a key measure of the risk of a bond, however, there are plenty of other risks that bond investors are taking on. Lindsey outlines some of these risks, including credit and liquidity risk.

Many bond market commentators will use duration as a key measure of the risk of a bond, however, there are plenty of other risks that bond investors are taking on. Lindsey outlines some of these risks, including credit and liquidity risk.

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Risks Inherent in Bonds

10 mins 15 secs

Key learning objectives:

  • Define the major risks associated with bonds

  • Identify the relationship between risk and return in the bond market

Overview:

Investing in bonds presents investors with a variety of risks to analyse. Some included are credit risk, credit spreads risk and liquidity risk.

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Summary

What is credit risk?

Arguably, the most significant bond risk is credit risk. Bonds are, essentially, securities which represent the issuer borrowing money. Whenever money is borrowed there is an expectation that it will be paid back, with interest, but there is a chance that the borrower will fail to do this – that they will default on their obligations by not fulfilling them.

Creditors may perform a credit analysis where they analyse the borrower through:

  • Its character - what it is like as a company or as a national government
  • Its capacity to take on debt
  • Its cash flow generation to service that debt
  • Any protections or covenants that the borrower may provide to the investor
  • Any collateral or security that is provided to protect the investor in the event of default

The best credits, with the lowest probability of default, are rated “Triple A”. As you go down the credit spectrum you move down through investment grade into sub-investment grade or “high yield” bonds. These credit ratings are relied on a huge amount by investors and many others throughout the bond industry.

What are credit spreads?

The spread is the amount of extra yield that the investor receives over and above the Treasury bond yield and compensates the investor for taking the added default risk.

Note that, for all except the high yield bonds, the spreads get larger with maturity.

What is credit spread risk?

There is another, closely related, risk that the investors also bears – and that is credit spread risk. If the credit spread on the bond changes after the bond has been bought, then the price that the bond can be sold at will change and the portfolio will have made or lost money.

What is liquidity risk?

Whilst US treasury bonds are very liquid and positions in these can easily be traded in and out of in large size, liquidity on other bond issues is often not so good, especially as we go down the credit spectrum. When buying a less liquid bond, an investor is not so certain they will be able to easily turn their bond position immediately back into cash. It is for this reason that people say bonds have greater “liquidity risk” and that the spread, as well as compensating for the risk of default, also includes a liquidity premium – which is the extra spread that is paid to the investor for taking the risk of illiquidity- that they will not be readily able to sell their bonds.

What are some other risks?

We have seen the main categories of risk borne by bond investors – interest rate risk, credit default risk, credit spread risk, liquidity risk.

But there are a whole host of other potential risks:

  • Bonds may have explicit inflation risk from having inflation-linked cash flows
  • They may have options to redeem early and so have the risks associated with that optionality such as volatility risk
  • They have currency risk if they are in a different currency to the investors base currency
  • There is funding risk if money is borrowed to buy the bond

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Lindsey Matthews

Lindsey Matthews

Lindsey runs Perfordiant, an investment risk and performance consulting firm. He has worked in financial markets since 1992. Lindsey became an MD in fixed income and equities, ran a Risk function, and was on the management team of an Asset Management fintech business. Lindsey is now a Visiting Fellow at the Henley Business School, and resides on the board of CFA UK.

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