Question

Q1] List and briefly describe 3 major risks in bond investing.

Q2] Which class of bonds is not affected by one of the three major risks in bond investing listed in Q1, and which specific risk is it?

Q3] What is the bond market’s single main mechanism for incorporating risks in bonds?

Q4] How is the bond market’s mechanism listed in Q3 related to bond prices? Include a brief description of how it affects or interacts with bond prices.

Q5.a) A portfolio manager wants to estimate the interest rate risk of a bond using duration. The current price of the bond is 98. A valuation model found that if interest rates decline by 35 basis points, the price will increase to 101 and if interest rates increase by 35 basis points, the price will decline to 96. What is the duration of this bond?

b) A portfolio manager purchased a bond portfolio with a market value of $75 million. The portfolio’s duration is 12. Estimate the change in the market value of the bond portfolio for a parallel shift in interest rates of +250 basis points. Comment on this duration based estimate of the market value change.

Answer 1

I can only answer 1 question at a time, so I am answering only question 1.

1] 3 major risks in bond investing are:

• interest rate risk: In general, rising interest rates means falling bond prices, hence it is considered as a risk.
• Credit risk: This is the risk that an issuer will be unable to make interest or principal payments on the due date.
• Inflation risk: It is always there with any type of assets (which includes bonds too).

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