FM for Actuaries

Bonds and Bond Pricing 189
hand, bonds issued by corporations, provincial governments and other institutions
may not be default free. Based on the bond issuer’s financial strength, bond rating
agencies provide a rating (a measure of the quality and safety) of the bond. The
evaluation by a rating service provider indicates the likelihood that the bond issuer
will be able to meet scheduled interest and principal repayments. Bonds with strong
credit standing are called investment-grade bonds, while bonds with weak credit
standing are called junk bonds (a riskier class).
Reinvestment risk: For coupon-paying bonds, investors receive interest payments
periodically before the redemption date. The reinvestment of these interest payments
(sometimes referred to as interest-on-interest) depends on the prevailing
interest-rate level at the time of reinvestment. Volatility in the reinvestment rate
of return due to changes in market interest rates is called reinvestment risk. Zerocoupon
bonds do not have reinvestment risk, as they do not have periodic coupon
payments. Investors purchase a zero-coupon bond at a discount to its redemption
value and receive a single redemption payment at a specified time in the future.
Call risk: The issuer of a callable bond has the right to redeem the bond prior to
its maturity date at a preset call price under certain conditions, which are specified
at the bond issue date and are known to the investors. The issuer will typically
consider calling a bond if it is paying a higher coupon rate than the prevailing
market interest rate. The call risk has three impacts on a bond investor: (a) the cashflow
pattern becomes uncertain, (b) the investor becomes exposed to reinvestment
risk because she may receive redemption payments before maturity, and (c) the
capital appreciation potential of the bond will be reduced, because bond issuers
typically call the bond when its market price is higher than the call price. Callable
bonds often carry a call protection provision. It specifies a period of time during
which the bond cannot be called.
Inflation risk: Inflation risk arises because of the uncertainty in the real value
(i.e., purchasing power) of the cash flows from a bond due to inflation. Inflationindexed
bonds are popular among investors who do not wish to bear the inflation
risk. An indexed bond has a fixed coupon rate (just like a conventional bond), while
its principal value may be adjusted upward or downward periodically based on a
defined inflation index (usually the adjustment dates are set at the coupon-payment
dates). In this manner, the interest income is also adjusted for inflation. However,
the principal value of the bond may be reduced during the indexed bond’s term if
there is deflation.
In addition to the aforementioned, there may be other risks in investing in
bonds. For examples, market risk is the risk that the bond market as a whole declines.
Event risk arises when some events occur and they have negative impacts