In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments . We had also looked into some of the factors, which affect the pricing and valuations of bonds .
Although debt market instruments offer safe returns, they are not
entirely risk free. There are several risks associated, arising mainly
from change in external factors. Change in interest rate is the most
influential risk, which primarily affects bond prices. We had earlier
analysed the impact of interest rate risk and effect of other factors
like monetary policy, fiscal policy, economic growth and inflation on
bond prices. The purpose of this article is to highlight some of the
other market related risks, which also influence bond prices. Some of
the key risks factors associated with bond valuations are listed as
follows:
Interest rate risk: Since we had already mentioned about
interest rate risk in our previous articles, we will not go in its
detail analysis. But just to refresh our memories, there is an inverse
relationship between changes in interest rates and bond prices. The
value of a bond is the sum total of the present value of its fixed
future cash flows, discounted at the appropriate current market interest
rate. Therefore, when the interest rate increases, a bond's value drops
and vice-versa.
A bond with longer maturity and higher yield will normally have less
impact on price due to change in interest rates. On the other hand, an
instrument with shorter maturity and low yield will tend to have larger
impact on its price. The price volatility for low maturity and low yield
instrument would however be on the lower side, as future cash inflows
are lower compared to bond with long maturity period.
Let's take the practical example in order to understand the relationship
between maturity, bond price and yield. As can be seen from the table
above, bond having the highest yield to maturity (YTM) of 22.7% and
longer duration (in this case 6 years) will be relatively more volatile
compared to a bond having short maturity and low YTM (6.5% instrument
having YTM of 12%). However, impact on price due to change in interest
rate will be more on bond having a short maturity and low yield.
Call and prepayment risk: The issuer can call a bond if the call
price is below the theoretical market price due to falling interest
rates. This is due to the fact that if interest rate declines issuer can
raise fresh funds at lower interest rates and would repay the loans
raised earlier carrying higher interest rates. Also, the possibility of a
call limits or caps the potential for price appreciation (if interest
rate falls bond price can rise near the call price and not more than
that). In India bonds issued with call options are generally not traded
in markets (not listed). IDBI Flexibond 1992 issue (interest rate of
about 16.5%) is the latest example of issuer calling the bond. The bond
was originally issued for 25 years tenure, with a put and call option
after every five years. The decision of the institution has come in the
wake of softer interest rate scenario. IDBI could now raise fresh funds
by about 500 basis points lower than the earlier 16% debt. Thus before
investing in a non-government bond, the investor should evaluate the
terms given for call option by the issuer which is likely to impact
investor's future cash inflow.
Reinvestment risk: The bondholder is exposed to the risk of
investing the proceeds of the bond (or coupon payments) at lower
interest rates after the bond is called. This is known as reinvestment
risk. The risk is intense for those investors who depend on a bond's
coupon payments for most part of their returns. Reinvestment risk
becomes more problematic with longer time horizons and when the current
coupons being reinvested are relatively large. Home loan and personal
finance companies are generally affected when home and auto buyers
prepay their loans. In the lower interest rate environment, the finance
companies get back their money sooner than expected, which adversely
affects their future revenues.
Credit risk: For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk.
Credit spread risk is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs.
Liquidity risk: It is the risk that represents the likelihood
that an investor will be unable to sell the security quickly and at a
fair price. Illiquid security will also have the risk of large price
volatility. Quantitatively liquidity risk can be estimated through
Bid-ask spread. Bid price represents the price at which dealers are
willing to buy the security from traders/investors and ask price
represents the price at which they are willing to sell the security to
investors. The bid price is lower than the ask. The spread between these
two prices is known as the bid-ask spread and it is used as a measure
of a security's liquidity. High spreads signal an illiquid market.
Investors like liquid markets so that they can buy and sell securities
quickly and at a fair price. Liquidity may also improve as more
participants actively engage in trading a security.
For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the
most actively traded instruments with a longer maturity period. Thus it
offers good liquidity to investors who can buy/sell the instrument
easily. On the other hand instrument with a coupon rate of 10.8% with a
maturity period of 13 years, although offers high YTM of 6.5%, has a
relatively low liquidity.
Exchange rate risk: When bond payments (coupons/principal) are
denominated in a currency other than the home currency of the bond
holder, the investor bears the risk of receiving an uncertain amount
when these payments are converted into the home currency. For example if
rupee appreciates against the foreign currency (US$) of the bond
payments, each US$ will be worth less in terms of rupee. This
uncertainty related to adverse exchange rate movements in known as the
exchange-rate risk or simply the currency risk.
Inflation risk: It refers to the possibility that prices of
general goods and services will increase in the economy. Since fixed
coupon bonds pay a constant coupon, increasing prices erode the buying
power associated with bond payments. This is known as the inflation
risk. For example, if a risk free bond has a coupon rate of 7.5%, and
prices increase at the rate of 4% per year, the investor's real return
is 3.5%. Higher inflation rates result in a reduction of the purchasing
power of bond payments (principal and interest).
Event risk: These are generally related to the occurrence of a
particular event and its impact on bond price. These can be listed as
disasters, corporate restructuring, regulatory issues and political
risk. Disasters (earthquakes or industrial actions) may impair the
ability of a corporation to meet its debt obligations. Corporate
restructuring (mergers, spin offs) may affect the obligations of the
company by impacting its cash flow or the underlying assets that serve
as a collateral. Regulatory issues such as environmental and other
restrictions may impose compliance costs on the issuer, impacting its
cash flow negatively. Political risk consisting of changes in the
government or restrictions imposed on foreign exchange flows can limit
the ability of the borrower to meet its foreign exchange obligations.
Volumes in the debt market are improving on increasing demand from
banks. With credit growth in the system tinkering down, banks are
investing in government securities over and above the minimum
requirement for SLR. This has offered the good liquidity to the markets.
Although, the bias is towards softer interest rates, retail investor
should take into account the above risk factors before investing into a
debt instrument. This is due to the fact that actual yield earned is
determined by the price of a bond which is again the factor of the above
listed risks.
|
This decade-old blog is formed for sharing useful info from financial world free of cost .All posts here are for reference purpose only. It is advisable to study and learn the investment process and decision making criteria yourself .Users are advised to rely on their own judgement or investment advisor when any making investment decisions. Any investment decision should be taken with your own analysis and risk. The blog is aimed to promote the awareness of stock markets among retail investors.
No comments:
Post a Comment