Question

Corporate bonds offer a series of fixed payments consisting of interest payments and face value at maturity. As so, managers of financial intermediaries like pension funds and insurance companies frequently utilize such instruments to achieve their financing objectives.

Questions for discussion:

What is assumed the interest payments can be reinvested at?

What is interest rate risk and what would happen to the price of a bond given interest rates increase?

Assume the manager of a $100 million portfolio of corporate bonds predicts interest rates will rise in the near future.

What adjustments should be made to the portfolio assuming the market has not already adjusted for this prediction?

Will a long-term zero coupon bond have more or less interest rate risk than a comparable coupon paying bond?

Answer 1

1. When an investor invests in a bond / fixed income instrument, the most important calculation is that of 'Yield to maturity' which can be defined as the per annum yield the bond is going to generate if held by the investor till its maturity. In order to calculate yield to maturity, the coupon payments and maturity value of the bond is considered. While there is no doubt that a bond will pay interest and principal on maturity as per the terms of the bond issue, however, there is no certainty that the intermediate coupon payments will be reinvested at the 'yield to maturity' rate of the bond and hence, an investor assumes while making an investment that he will be able to reinvest the coupon payments at the rate of 'yield to maturity' of the bond and therefore, the bond investment would offer a compounded return at the rate of 'yield to maturity'
2. Interest rate risks refer to the risks to a bond investor that arises due to fluctuations in the market value of his bond investments due to movement in interest rates in the economy. The market value of bonds is directly linked to the interest rates in the economy as a bond's yield is benchmarked on the said interest rates adjusted for the risk profile of the bond. Therefore , a bond investor always carries a risk that the value of his bond portfolio may fluctuate in response to the fluctuation in benchmark interest rates. If interest rates go up, the bond prices fall down to push their yields higher in line with the increased interest rates
3. If a manager of a $100m bond portfolio thinks that the interest rates will go up in near future and market prices haven't already adjusted this prediction, than he must sell his bond positions at the present as bond prices will fall once interest rates go up and his portfolio will take a hit. After the hike in interest rates, he can again enter the bond market at much cheaper prices and further, his portfolio in that case will enjoy higher interest rates.
4. Zero coupon bonds have higher interest rate risks than coupon paying bonds because there is no coupon payments in zero coupon bonds, which means that their market values become extremely volatile to any changes in interest rates. Since, an investor in a zero coupon bond gets no interest income and only has opportunities of capital gain, he is more prone to interest rate risks if the bond can't be held to maturity and has to be sold off in the secondary market before that.