BONDS

Liquidity Preference
Theory

Proponents of the liquidity preference

theory believe that, in general:

Investors prefer to invest short term rather than

long term
Borrowers must entice lenders to lengthen their
investment horizon by paying a premium for longterm money (the liquidity premium)

Under this theory, forward rates are higher

than the expected interest rate in a year

Inflation Premium Theory

The inflation premium theory states that
risk comes from the uncertainty associated
with future inflation rates
Investors who commit funds for long periods
are bearing more purchasing power risk
than short-term investors

More inflation risk means longer-term investment

will carry a higher yield

Bond Risk
Price risks
Malkiels interest rate theories
Duration as a measure of interest rate risk

Risks
Interest rate risk
Price risk
Reinvestment risk
Default risk

Interest Rate Risk

Interest rate risk is the chance of loss
because of changing interest rates
The
uncertainty
concerning
bond
values/prices
due
to
interest
rate
fluctuations are called interest rate risk

Examples 1. zerocoupon
2. coupon bonds

Interest rate risk

Bond prices are sensitive to the

market interest rate

If interest rates rise, the market

value of bonds fall in order to
compete with newly issued bonds
with higher coupon rates.

Sensitivity to the interest rate

chance become more severe for
longer term bonds

Percentage rise in price is not

symmetric with percentage decline.

Reinvestment Rate Risk

Reinvestment rate risk refers to the

uncertainty surrounding the rate at which
coupon proceeds can be invested

The higher the coupon rate on a bond, the

higher its reinvestment rate risk

Corporate Bonds

They almost always pay coupons

Like Government bomds, they are exposed

to interest rate risk
But they also subject to default risk

Default Risk

Default risk measures the likelihood that a

firm will be unable to pay the principal and
interest on a bond

CRISIL. ICRA and CARE are the leading

advisory services in monitoring default risk

10

Default Risk (contd)

Investment grade bonds are bonds rated

BBB or above

Junk bonds are rated below BBB

The lower the grade of a bond, the higher

its yield to maturity

11

Pricing of corporate bonds

Suppose you have two bonds with same
maturities and same coupon rates, but one
is a government bond and other is a
corporate bond,
which will sell for less?
why?

Theorem 1

Bond prices move inversely with yields:

If interest rates rise, the price of an existing bond
declines
If interest rates decline, the price of an existing
bond increases

13

Theorem 2

Bonds with longer maturities will fluctuate

more if interest rates change

Long-term bonds have more interest rate

risk

14

Theorem 3

Higher coupon bonds have less interest rate

risk

Money in hand is a sure thing while the

present value of an anticipated future
receipt is risky

15

TYPES

Duration as A Measure of
Interest Rate Risk
The concept of duration
Calculating duration

17

The Concept of Duration

For a noncallable security:

Duration is the weighted average number of
years necessary to recover the initial cost of the
bond
Where the weights reflect the time value of
money

18

The Concept of
Duration (contd)

Duration is a direct measure of interest rate

risk:
The higher the duration, the higher the interest
rate risk

19

Inflation and Interest

Rates
Real rate of interest change in
purchasing power
Nominal rate of interest quoted rate of
interest, change in purchasing power,
and inflation
The ex ante nominal rate of interest
includes our desired real rate of return
plus an adjustment for expected inflation

20

The Fisher Effect

The Fisher Effect defines the relationship
between real rates, nominal rates, and
inflation
(1 + R) = (1 + r)(1 + h), where

R = nominal rate
r = real rate
h = expected inflation rate

Approximation
R=r+h

21

The Bond Indenture

Contract between the company and the

bondholders and includes
The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if
applicable
Sinking fund provisions
Call provisions
Details of protective covenants

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Priority of claims in
liquidation
1.
2.
3.
4.
5.
6.
7.

Secured creditors from sales of

secured assets.
Wages, subject to limits
Taxes
Unfunded pension liabilities
Unsecured creditors
Preferred stock
Common stock