Bond Prices, Risks, and Management
In the previous chapter, we calculated the returns. But why does the price of a bond change in the first place? In this final chapter, we explore the "Physics" of bond pricing and how professional managers handle bond portfolios.
1. Bond Pricing (The Inverse Relationship)
The most fundamental rule of the bond market is: Bond prices and interest rates move in opposite directions.
- If market interest rates Rise → Existing bond prices Fall.
- If market interest rates Fall → Existing bond prices Rise.
Why?
If you hold a bond paying 8% and the government releases new bonds at 10%, no one will want to buy your 8% bond at full price. You must lower your price to make your bond attractive again.
2. Risks in Bond Investment
Bonds are "safer" than stocks, but they are not "risk-free."
| Type of Risk | Description |
|---|---|
| Interest Rate Risk | The risk that rising interest rates will cause the bond's price to drop. |
| Default (Credit) Risk | The risk that the company will go bankrupt and not pay the interest or principal. |
| Inflation Risk | The risk that the fixed interest won't be enough to match the rising cost of living. |
| Liquidity Risk | The risk of not being able to sell the bond quickly at a fair price. |
| Reinvestment Risk | The risk that when you get your interest, the market rates have fallen, and you can't reinvest it at the same high rate. |
3. Bond Management Strategies
Professional fund managers use two main approaches to manage bond portfolios:
A. Passive Bond Management
- Goal: To match the performance of a benchmark (like a Bond Index).
- Buy and Hold: Buying bonds and holding them until maturity.
- Indexing: Creating a portfolio that mirrors a government bond index.
B. Active Bond Management
- Goal: To beat the market and earn extra profit.
- Interest Rate Anticipation: If the manager thinks rates will fall, they buy long-term bonds.
- Valuation Analysis: Finding "mispriced" bonds in the market.
- Sector Rotation: Moving money from corporate bonds to government bonds based on the economy.
The Concept of Duration
Duration is a measure of how sensitive a bond's price is to a change in interest rates.
- A bond with a High Duration (long term) will crash harder if interest rates rise.
- A bond with a Low Duration (short term) is safer during rising rate environments.
Exam Pattern Questions and Answers
Question 1: "Explain the inverse relationship between Bond Prices and Interest Rates." (6 Marks)
Answer: The inverse relationship is the core principle of fixed-income mathematics.
- Market Competition: When interest rates in the economy rise, newly issued bonds offer higher coupon rates.
- Valuation Change: To make an older bond (with a lower coupon) competitive, its market price must decrease so that its 'Yield to Maturity' equals the new market rate.
- Mathematical Basis: The price of a bond is the 'Present Value' of its future cash flows. Since interest rates are used as the 'Discount Factor' in the denominator, a higher rate (denominator) leads to a lower price (result).
- Example: If rates go from 6% to 8%, a 6% bond becomes less valuable, and its price will drop below its face value.
Question 2: "Discuss 'Interest Rate Risk' and 'Default Risk' in bond investing." (6 Marks)
Answer:
- Interest Rate Risk: This is the most common risk for bondholders. It refers to the risk of capital loss because of a change in market interest rates. High-duration (long-term) bonds are more exposed to this risk. If an investor needs to sell their bond before maturity during a high-rate period, they will suffer a loss.
- Default (Credit) Risk: This refers to the possibility that the issuer (the company or municipality) will fail to make timely payments of interest or principal. Government bonds (G-Secs) are considered to have zero default risk, while corporate bonds are 'Rated' (AAA, AA, B, etc.) by agencies like CRISIL to help investors understand this risk.
Summary
- Bond prices move opposite to interest rates.
- Long-term bonds are riskier than short-term bonds.
- Active management tries to predict interest rate movements.
- Default risk is the biggest concern for corporate bondholders.
Quiz Time! 🎯
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