Question

Other things held constant, What is the relationship between the time to maturity and interest rate sensitivity of bonds? explain bonds with higher and lower maturity pros and cons

Answer 1

What is the relationship between the time to maturity and interest rate sensitivity of bonds?

Interest rate sensitivity is a measure of how much the price of a fixed-income asset will fluctuate as a result of changes in the interest rate environment. Securities that are more sensitive have greater price fluctuations than those with less sensitivity. This type of sensitivity must be taken into account when selecting a bond or other fixed-income instrument the investor may sell in the secondary market.

How Interest Rate Sensitivity Works

Fixed-income securities and interest rates are inversely correlated. Therefore, as interest rates rise, prices of fixed-income securities tend to fall. When applied to calculate fixed income securities, interest rate sensitivity is known as the asset's duration. This is one way to determine how interest rates affect a fixed-income security portfolio. The higher a bond or bond fund's duration, the more sensitive the bond or bond fund to changes in interest rates.

The duration of fixed-income securities gives investors an idea of the sensitivity to potential interest rate changes. Duration is a good measure of interest rate sensitivity because the calculation includes multiple bond characteristics, such as coupon payments and maturity.

Generally, the longer the maturity of the asset, the more sensitive the asset to changes in interest rates. Changes in interest rates are watched closely by bond and fixed-income traders, as the resulting price fluctuations affect the overall yield of the securities. Investors who understand the concept of duration can immunize their fixed-income portfolios to changes in short-term interest rates.

Explain bonds with higher and lower maturity pros and cons

The term junk bond makes people think of a worthless investment. Though there may have been a time over 30 years ago when this name had rightfully been earned, the reality today is that the term simply refers to bonds issued by less than investment-grade businesses. These bonds are often called high-yield corporate bonds. Unlike the name “junk bond” suggests, some of these bonds are an excellent option for investors. Just because a bond issuer is currently rated at lower than investment-grade, that doesn’t mean the bond will fail. In fact, in many, many cases, high-yield corporate bonds do not fail at all and pay back much higher returns than their investment-grade counterparts.

Another important point is that even though these bonds are considered riskier than other bonds, they still are more stable (less volatile) than the stock market, so they offer a sort of middle ground between the traditionally higher-payout, higher-risk stock market, and the more stable lower-payout, lower-risk bond market. Ultimately, no stock or bond is guaranteed to reap returns and in the grand scheme of investment opportunities, junk bonds are by no means the riskiest option out there.

Still, given they are riskier than traditional bonds, many junk bonds should be avoided based upon the specific circumstances of the company issuing them. Shrewd investors, therefore, investigate the bonds and weigh the pros and cons of each issuer against each other to determine whether or not a particular high-yield corporate bond is a wise investment.

The Advantages

There are several features of high-yield corporate bonds that can make them attractive to investors:

1. They offer a higher payout compared to traditional investment grade bonds: This is the big one. It all comes down to money. Simply put, because the companies issuing these bonds do not have an investment-grade rating, they must offer a higher ROI. This means that if a junk bond pays out, it will always pay out more than a similar sized investment-grade bond.
2. If the company who issues the bond improves their credit standing, the bond may appreciate as well: When it is clear a company is doing the right things to improve their credit standing, investing in high-yield bonds before they reach investment-grade can be an excellent way to increase the return while still enjoying the security of an investment-grade bond. Investors often thoroughly research companies offering high-yield bonds to find such “rising stars” as they are often referred to in the bond market.
3. Bondholders get paid out before stockholders when a company fails. If a business is risky, yet you still want to invest in it, bondholders will get paid out first before stockholders during the liquidation of assets. Ultimately a company defaulting means the bonds and stocks it issued are worthless, but since bondholders get paid out first, they have a greater chance of getting some money back on their investment over stockholders in the event of such a default. Once again, the name “junk” can be very misleading as such bonds can clearly provide a safer investment over stocks.
4. They offer a higher payout than traditional bonds but are a more dependable ROI than stocks. The first point on this list was that these bonds offer a higher ROI than traditional bonds. But on the flip side, they also offer a more reliable payout than stocks. Whereas the high-payout of stocks can vary based upon company performance, with a high-yield corporate bond, the payout will be consistent each pay period unless the company defaults.
5. Recession-resistant companies may be underrated. The big deal with high-yield corporate bonds is that when a recession hits, the companies issuing these are the first to go. However, some companies that don’t have an investment-grade rating on their bonds are recession-resistant because they boom at such times. That makes the companies issuing these types of bonds safer, and perhaps even more attractive during economic downtimes. A great example of these types of companies are discount retailers and gold miners.

Keep in mind that many of the companies out there issuing these bonds are good, solid, reputable companies who have just fallen on hard times because of a bad season, compounding mistakes, or other hardships. These things can make a company’s debt obligations skyrocket and drop their rating. Carefully researching the market, industry, and company can help reveal if the company is just going through a hard time, or if they are headed towards default. Shrewd bond investors regularly look at high-yield bond investment opportunities to help increase the yield on their fixed-income portfolio with great success. This is because such high-yield bonds provide a larger consistent ROI than government issued bonds, investment grade bonds, or CDs.

Stock investors also often turn to high-yield corporate bonds to fill out their portfolios as well. This is because such bonds are less vulnerable to fluctuations in interest rates, so they diversify, reduce the overall risk, and increase the stability of such high-yield investment portfolios.

The Cons of High-Yield Corporate Bonds

There are several negative aspects of high-yield corporate bonds that investors must consider as well to make a shrewd investment:

1. Higher default rates. There’s no way around this, the only reason high-yield bonds are high-yield is because they carry with them a greater chance of default than traditional investment-grade bonds. Since a default means the company’s bonds are worthless, this makes such investments far more risky to include in a portfolio of traditional bonds. However, it should be noted that when a company defaults, they payout bonds before stocks during liquidation, so bondholders still have greater security than stock market investors. When mitigating risk is the primary concern, high-yield corporate bonds should be avoided.
2. They are not as fluid as investment-grade bonds. As a result of the traditional stigma attached to “junk bonds,” many investors are hesitant to invest in such bonds. This means that reselling a high-yield bond can be more difficult than a traditional investment-grade bond. For investors who want to ensure they have the freedom to resell their bonds, high-yield corporate bonds are not as attractive.
3. The value/price of a high-yield corporate bond can be affected by a drop in the issuer’s credit rating. This is true of traditional bonds as well, but high-yield are far more often affected by such changes (migration risk). If the credit rating goes down further, the price of the bond can go down as well, which can drastically reduce the ROI.
4. The value/price of a high-yield corporate bond is also affected by changes in the interest rate. Changes in interest rates can affect all bonds, not just high-yield bonds. If the interest rate increases, the value of the bond will decrease. If it falls, the value conversely goes up, so this is a two-way street, there just is a much greater chance of this going the wrong way with a high-yield bond over a traditional investment-grade bond.
5. High-yield corporate bonds are the first to go during a recession. Traditionally, the junk bond market has been hit very hard by recessions. Though other bonds may see their value go up as a way to attract such investors at these times, those who were already issuing high-yield bonds can’t do this and often begin to fail as other bond opportunities become more attractive to investors. This means that during a recession almost all junk bonds unless they are in recession-resistant industries, run a much higher risk than normal of becoming worthless.

The Bottom Line

Yes, high-yield corporate bonds are more volatile and, therefore, riskier than investment-grade and government-issued bonds. However, these securities can also provide significant advantages when analyzed in-depth. It all comes down to money. Simply put, because certain issuers do not have an investment-grade rating, they must offer a higher ROIs and therefore, it clearly depends on the investors' risk profiles.