Chapter 4: Understanding fixed- income risk and return

Sources of return

2. Reinvestment of coupon payments

  1. Potential capital gain/ loss on the sale of the bond prior to maturity
  1. Coupon + Principal Payments on the scheduled date

Factors that affect return on a fixed- rate bond

credit risk (potential default on the payments)

interest rate risk (varying coupon reinvestment rate and sale price)

A horizon yield: internal rate of return (IRR) between the total return for the investment horizon and the purchase price of the bond (example 1-7 in the text book)

A carrying value: the purchase price plus/ minus the amortized amount of the discount/ premium if the bond is purchased at a price below/ above par value

Investment horizon and interest rate risk

Interest rate risk

Coupon reinvestment risk

Market price risk (capital gain/ loss of selling the bond prior to maturity) - inversely related with the interest rate

Coupon reinvestment income decrease when the interest rate decrease

Coupon reinvestment income increase when interest rate increase (directly related to each other)

Interest rate risk on fixed- rate bonds

duration: sensitivity of the bond's full price to change in the bond's YTM (or to change in benchmark interest rates)

Yield duration: with respect to YTM

Curve duration: respect to benchmark yield curve

Yield duration statistics

  1. Modified duration: direct measure of the interest rate sensitivity of the bond (assume: yield changes do not change the expected CF - no default). It also provides a linear estimates (approximately equal) of the % price change given a change in YTM
  1. Money duration
  1. Macaulay duration
  1. Price value of a basis point (PVBP)

Duration principles

  1. Maturity increases => duration increases => bond becomes more volatile
  1. Coupon increases => duration decreases => bond becomes less volatile
  1. Interest rates increase => duration decreases and bond's sensitivity goes down