Download - Fixed Income Risks
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RisksAssociatedwithFixed
IncomeSecuri8es
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ReturnComponents
Returnobtainedfrominves8nginafixedincomesecurityfromthedayitispurchased
tothedayitissoldhastwocomponents:
ChangeinmarketvalueCashflowsreceivedfromthesecurityduringthe8meitisheld,plusaddi8onalincomefrom
reinvestmentofthesecashflows
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RisksAssociatedwithFixedIncome
Investments Market,orinterestraterisk Reinvestmentrisk Timing,orcall,risk Credit,ordefault,risk Yieldcurve,ormaturity,risk Infla8on,orpurchasingpower,risk Liquidityrisk Exchangerate,orcurrency,risk
Vola8lityrisk Poli8calorlegalrisk
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InterestRateRisk
Mostimportantriskformostfixedincomeinvestors.
Usually,thevalueofafixedincomesecuritydecreasesasinterestratesrise.
Sellingwhenrateshaverisenwillresultinaloss. Thereareexcep8ons(e.g.putop8ons). Domes8ctreasuryyieldcurveismostcommonbenchmarkformeasuringratechanges.
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ReinvestmentRisk
Returnearnedwhenreinves8ngthecashflowsofafixedincomesecuritydependson
theprevailingmarketrateswhenthosecash
flowsarereceived. Theriskisthatrateswillbelowwhencashflowsbecomeavailableforreinvestment.
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Timing/CallRisk
Ifthefixedincomesecurityhasacallprovision,thecashflowsreceivedareuncertain.
Callfeaturesexacerbaterevinvestmentrisk:Bondswilltendtobecalledwheninterestratesarelow(issuercangetcheaperfundingbyrefinancing).
Aversionofthisriskistheprepaymentriskofmortgagebackedsecuri8es.
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CreditRisk
Riskduetoachangeinthecreditworthinessoftheissuer.
DefaultriskRecoveryrisk
Migra8onrisk Spreadrisk(oenconsideredapartofmarketrisk).
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TreasuryEurodollar Spread (TED Spread)
Source:Wikipedia
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YieldCurve/MaturityRisk
Theyieldcurvereferstothecurrentmarketinforma8ongivingtheyieldtomaturityforbondsofdifferentdura8ons.
Itcanbeusedtomakeassump8onsaboutthefuturebehaviourofinterestrates.
Investmentdecisionsmaybemadebasedonapar8cularassump8ononthebehaviouroftheyieldcurve.Theobtainedreturnwillbeaffectedbydevia8onsof
actualinterestratesthatprevailinthefuturefromthoseinferredfromthecurrentyieldcurve.
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Infla8onRisk
Infla8onaffectsthevalueoffuturecashflows,whenmeasuredintermsofpurchasingpower.
Unlessthebondisinfla8onlinked,theholderhasanexposuretothisrisk.
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LiquidityRisk
FlighttoqualityscenariosInvestorsrushtothesafestpossiblesecuri8es(e.g.U.S.treasuries)
Pricesofallothersecuri8esdropdrama8callyE.g.AugustSeptember199,September200
Wideningbidaskspreads(highertransac8onscostsduetolowerliquidity).
Fundingliquidityrisk(illiquidvs.insolvent).
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ExchangeRateRisk
Receivingcashflows(e.g.fromholdingabond)inacurrencyotherthanthedomes8c
currencyexposesaninvestortoexchangerate
risk. Holdingbondsissuedinanothercountryalsoexposesaninvestortotheinterestraterisk
fromthatcountry.
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Vola8lityRisk
Interestratevola8lityaffectsthevalueofop8onsembeddedinbonds(e.g.callable,putablebonds,prepaymentop8onsembeddedinmortgagebackedsecuri8es).
Thevalueoftheseop8onsincreaseswithincreasingratevola8lity.
Iftheseop8onsaregrantedtotheissuer(asincallablebonds,MBS)thepriceofthesecuritywilldecreasewhenvola8lityincreases.
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Poli8cal/LegalRisk
Taxpolicy Abilitytoenforcebondcovenants Legalstatusofthedebt(e.g.withinbankruptcy,restructuring)
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EventandSectorRisk
EventRisk:Theabilityofanissuertomeetitsobliga8onsmightbeaffectedbyaseriousand
unexpectedchangeduetoasuddenevent.
NaturalorindustrialaccidentTakeoverorcorporaterestructuring
SectorRisk:Riskduetothepossibilityofadversedifferen8almovementsofspecific
sectorsofthemarket.