Question

1. Consider these three bonds:

1) USTN 10% due 3/31/2025 with a yield to maturity of 3.5%

2) USTN 3% due 3/31/2025 with a yield to maturity of 3.6%

3) USTN 10% due 12/31/18 with a yield to maturity of 3.1%

Which bond has the highest risk and which bond has the lowest risk. Tell me in your own words, what bond risk means to you. If you were investing in bonds and you believe interest rates will rise across the entire yield curve, which of these three bonds would you buy and why.

Answer 1

There is one basic principle related to bonds that is a rule of thumb:

Bonds are issued at a coupon rate: eg USTN 10% which means 10% of coupon payment, per annum. that means this bond would fetch an annual payment of 10% of its Face value annually till maturity and the Face value at end of the maturity.

Now during this period if the interest rates rise above 10%, the newer bonds issued would carry a higher coupon rate and hence, if someone wants to sell their 10% coupon rate bond, these bonds will have to carry a lower price to compete with higher bond coupons.

hence, interest rates and bond face value have an inverse relationship, with the vice versa of the above example to be true.

now there is YTM yield to maturity which basically means if we hold the coupon till its maturity how much would be our yield. This is nothing but discounting annual coupon payments and final amount at maturity to present value.

YTM and price of bond have inverse relationship, if the YTM goes above coupon rate then the price of bond goes below its face value, while the vice versa being true again.

Now in the example above, with example as mentioned above lowest risk is where we get least risk, hence, USTN 10% due 12/31/18 with a yield to maturity of 3.1%, has YTM< coupon rate. This is not the only reason for this being a low risk bond, given that its maturity is in 2018, and others have it in 2025 means that during these 7 years there could be many instances negatively impacting our bond prices and with a near term maturity we get an opportunity to invest in future bonds which might be of higher coupon rate, which we other wise would suffer holding a longer maturity bond with lesser coupon rates.

Riskiest bond(highest Risk) would be USTN 10% due 12/31/18 with a yield to maturity of 3.1%, as the YTM>Coupon rate and the price of the same would be lower now.

Bond risk is the risk of holding a bond and the interest rates change and become higher, so now the bond we hold loses its face value and its demand decreases and better coupons are available in market. This bond becomes less liquid.

If I were to invest in a bond with the knowledge that the interest rates would go up, I would invest in USTN 10% due 12/31/18 with a yield to maturity of 3.1% as the maturity is sooner and this bond would suffer least as compared to others having a longer maturity. A longer duration suggests more uncertainties.