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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10 mins 15 secs
Investing in bonds presents investors with a variety of risks to analyse. Some included are credit risk, credit spreads risk and liquidity risk.
Key learning objectives:
Define the major risks associated with bonds
Identify the relationship between risk and return in the bond market
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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:
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.
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.
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.
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.
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:
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