Interest Rate Risk

[Vikas Singh]

 

Dear Sir & Friends,

 

There are two bonds issued on the same day.

1st  -: 10 year Zero-Coupon Bond.

2nd -: 10 year 10% Coupon Bond.

The YTM, when issued, for both bonds was same as 12%.

 

Then which bond will have more interest rate risk? why?

 

Thanks & Regards
--
Vikas Kumar Singh
BIM, Trichy (26th Batch)

[manikandan s]

Hi friends,
                   Below is the answer given by govi

Answer: 10 year Zero coupon bond will have more interest rate risk.

Justification:
Higher the time to maturity, higher the interest rate risk.
Higher the coupon, lower the interest rate risk.

If there is only one payment (as in the case of zero coupon), the interest
rate will have the full effect on this *maturity value*. In case there are
many payments( coupon bonds) , the interest rate will have a *subdued* effect
and minimizes the interest rate risk.

Therefore  zero coupon bonds are more exposed to interest rate risks rather
than coupon bonds.
Atleast, you ll receive some cash in Coupon bonds, therefore it is less
susceptible.

Mathematically, u can see the inverse relation of coupon and YTM.

Regards
Prabhu

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MANIKANDAN

[Mani KG]

Hi ,

If longer time period of zero coupon bonds is a concern can somebody
tell why it is offered, I feel though it is affected by interest rate
risk
it has high duration meaning more sensitive to interest rate which can
be interpreted positive also.

regards,
manikg

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[Pradeep Melchis]

I'll leave the discussion of the interest rate sensitivity to you guys (you'll learn more of it in coming classes in SAPM or Fixed Income); I could through some light on a few reasons for zero-coupon bond issuance-

1. Corporations which are in nascent stages of project commissioning might not want the stress of an early cash outflow (in the form of interest payments), thus opting for zero-coupon bonds to raise money.
2. From an investor point of view, consider a capital protection fund. The fund manager is given Rs 1000 as an investment. He assures capital protection (meaning if I don't get returns, I assure the protection of Rs. 1000 invested). The fund manager then invests (1000-x) in a zero coupon bond (par value of 1000) matching the time horizon of investor. 'X' he invests in other assets. This way, at maturity the investor is assured of Rs. 1000, with the possibility of gains on the X amount invested in other asset classes. (The catch here is to get a Zero coupon bond of the same maturity). So, zero-coupons are useful in such cases.
   
3. Another practical example for issuing a zero coupon debenture. Consider a company in expansion mode. Its raises funds by issuing zero coupon compulsorily convertible debentures, to its own promoters. This helps in the following ways - one, the funds required for expansion are tied up; two, the interest payments are not made in cash thus reducing financial distress; three, the notional interest payments on a zero-coupon bond are ammortised, mean its brings in an element of tax-protection in the early years by reducing PAT; four, at maturity the bonds are compulsorily convertible allowing the company to save on cash outflow (in case they had to redeem the bonds); five, it allows the promoters to increase stake in the company, allowing to participate more in dividends

There could be many other reasons, you guys can share your thoughts on the same. A few questions on your interest rate sensitivity discussion -

• Does higher duration on a zero-coupon bond neccessarily mean its not a good investment choice. What about an investor whose investment in a zero coupon is long term and not for trading?
• Is high interest rate sensitivity good for a bond trader? what happens when the general market int rates rise. A low coupon bond would neccessarily have to lose value to match the rise in mkt interest rate. meaning - reduction in mkt price of bond ?? In that case the view on the market becomes critical.
• Which spectrum of the yield curve would you generally find bonds with higher duration?? 
• And one more, can someone tell exactly what duration means??? Its interpreted in a couple of different ways.
  

Please share your thoughts.  Good to see healthy activity in this group. :)

Cheers
Pradeep

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[Abhishek Roy]

Hi all,

       Feels good to be beck in the forum.

I would like to answer the query raised by Pradeep regarding what is "Duration"?

 We all know that duration is the percentage change in the price of a bond due to 1% change in the interest rate, but this is a very basic definition.

   

When we hear the word "duration" for the first time, the first thought that comes to our mind is that it should be something related to time,

actually it is related to time.

Duration as a concept comes from the Bond/Bond Portfolio immunization process, it says that if a Bond/Bond Portfolio's duration is say 4, then in order to immunize the same we need to hold it for exactly 4 years.

Simply,"Duration is the optimum number of years a Bond/Bond portfolio needs to be held in order to immunize it from interest rate risk"

Regards

Roy