Question

Bond prices can fall either because of a change in the general level of interest rates or because of an increased risk of default or a change in the real rate of return (otherwise known as opportunity cost of capital). To what extent do floating-rate bonds and puttable bonds protect the investor against each of these risks?

Be sure to support your statements with logic and argument

Answer 1

Price of bonds is inversely proportional to the prevailing market rate (i.e. the opportunity cost of capital). When market rate rises, bond prices fall and vice versa.

Unlike a fixed coupon bond where coupon rate is fixed till maturity, coupon rate for a floating rate bond adjusts periodically based on the prevailing federal rates with some spread rate added to it. Thus, coupon rate will move in tandem to the benchmark rates. In floating rate bonds, interest rate is mostly taken out of equation as bond holder will benefit from rising interest rates in the market as a whole. However, in decreasing interest rates, such bonds will yield lower interest rates. Main risk averted in these kinds of bonds is that of timing risk (risk of holding security of fixed coupon for specified time). Best time to buy such bonds would be when prevailing rates in the market are at low and expected to increase in coming times. Investing in floating rate bonds helps investors to keep up with prevailing rate of inflation.

Putable bonds give holders right to sell bond to the issuer itself before maturity. In the scenario of rising interest rates, bonds lose their value. Put option attached to bond helps investor to get bond redeemed at par value in event of considerable rise in interest rates in market overall. This option saves investor from reinvestment risk (exiting lower rate investment and re-enter at higher rate) and price depreciation risk (price will never go down below par value). Hence, this can be used as a hedging strategy against the market rate fluctuations as investor always has the option to redeem the bond at par value. These bonds are costlier than a traditional bond due to put option attached. Intrinsic cost of put option is the difference between cost of traditional bond and putable bond.