Question

why occurrence change in bond price as a function of change in yield to maturity and discuss how duration impacts the sensitivity of a bond.

why is the feature a concern?

what does this mean for investors?

can investors avoid this feature, why or why not?

Answer 1

(a)

The bond's price and yield to maturity are inversely related. This is so because the bond's price is a summed value of the discounted bond cash flows, in the form of periodic bond coupon payments and redemption of the bond's par value upon maturity.

Hence, a rise in the bond's yield to maturity leads to a fall in bond's prices and vice-versa. Therefore, in a scenario of rising interest rates (upward moving yield curve), the bond's prices will see a drop and in case of a downward moving yield curve, the opposite will happen.

(b) Bond Duration is a singular number measured in days, which rolls into itself bond features such as its coupon payments and their magnitude, the bond's maturity and more. The magnitude of the bond's duration (say 4.3 days) is a measure of the sensitivity of the bond's price to a percentage change in interest rates (yields) in either direction. In other words, a bond with duration 4.3 days will see its value fluctuate by 4.3% for every percentage fluctuation in bond yields. Bond Durations vary directly with bond maturity and inversely with bond coupon size. Hence, longer maturity, low coupon bonds are more sensitive to changes in yield as they possess higher durations. The opposite is true for shorter maturity, high coupon bonds.

(c) The relationship of interest rates to bond's duration and in turn its value is a concern because in a rising interest rate environment it depresses bond value. This implies that in a high or rising interest rate environment, borrowing is difficult, bonds are in low demand and have less price.Low bond prices reduce bond investors holding value and is, therefore, a cause for concern.

(d) As mentioned earlier, a high duration increases a bond's sensitivity to interest rate fluctuations and hence investors with bond's with such high durations imply increased risk to bond portfolio value from volatile interest rates.

(e) Investors can protect their bond portfolio values against rising interest rates through one or combination of the following ways:

- Investing in Floating Rate bonds which adjust their yield to pay more in case of fall in bond value, thereby compensating the loss-making impact of the same.

- Investing in shorter maturity bonds as they have low durations and hence less sensitivity to rising interest rates.

- Investing in high yield and high coupon rate bonds as they again have low durations and yields compensate for the falling value of bonds.

- Investing in Convertible or Emerging Market bonds, as emerging market bonds are more credit-sensitive instead of being yield sensitive.