Question

QUESTION 16

1. Define liquidity risk and explain how it relates to bonds and bond yields.

2. Define default risk and explain how it relate to bonds and bond yields.

Answer 1

LIQUIDITY RISK

Defination: -

Liquidity risk can be defined as the risk a lender (bond issuing company) fails to oblige with its bond obligations i.e. either makes default in making interest payments or repayment of borrowed fund due to the reason being shortage of available cash resources i.e. either due to non-availability of adequate cash or cash equivalent or its shortage due to failure of short term funding plans, sales target etc.

Relation with Bond and Bond yield: -

Liqidity risk is directly related with bond valuation and its yield calculation. Higher the chances of default, higher is the rate of interest charged by the lender i.e. higher will be the yield on bond and vise versa. An investor should always analyse liquidity strength of bond issuing company as it is one of the major determinants which analyses and calculates the repayment probability. Many finance experts claim that bond pricing, valuation and yield is directly dependent upon its liquidity risk. Also it is observed that liquidity crises affects the bond yield spreads especially during the tough market times like in case of highly volatile market scenarios.

Liquidity risk can also be understood from investors angle as inability of any investor to resell any bond already purchased either from primary or secondary market due to varied reason non availability of potential buyers, falling financial condition of issuing company, no future growth etc.

This risk is associated with working capital or marketability of bond.

One should always consider liquidity analysis of potential investment in bonds as its illiquidity may pose potential fund blocking and accordingly determine expected rate of return on bond i.e. yield to be realised. Keeping liquidity risk factor in mind, company should determine bond yield rate determination.

DEFAULT RISK

Defination: -

Default risk can be defined as the risk undertaken by the lender of fund with respect to probability of non-repayment of granted funds i.e. risk of bad debts or in simple words we can say that risk undertaken by lender of fund where borrower defaults in obliging its debt obligations.

Relation with Bond and Bond yield: -

Default risk is directly related with bond valuation and its yield calculation. Higher the chances of default, higher is the rate of interest charged by the lender i.e. higher will be the yield on bond and vise versa. One should always consider default risk whenever investment in bonds are considered. Since default in bond debt obligations will directly impact the profitability and even capital of lender/ investor. Default risk is dependent upon several common macro-economic factors like political environment, geographical coinstrants, market and economy while it also closes dependent upon individual borrower company like its intention and ability to repay money acquired via bonds or fulfil bond obligations.

Higher the chances of default, higher will be the interest charged by lenders of fund/ potential investors. Since they are willing to take higher risk, they will demand a higher remuneration i.e. return on capital invested. Therefore bond yield and default risk can be said as directly proportional to each other i.e. higher the chances of default, the higher will be bond demanded interest rate iand yield.