Question

1) Explain liquidity risk, default risk, and taxability risk. How does each of these risks affect the yield of a bond? 2) Define what is meant by interest rate risk. Assume the manager of a $100 million portfolio of corporate bonds predicts interest rates will rise in the near future. What adjustments should be made to the portfolio assuming the market has not already adjusted for this prediction? 3) Normally, the Treasury yield curve is upward-sloping. Explain the conditions required for a downward-sloping yield curve to exist. 4) Should investors be indifferent between two bonds which have equal market yields to maturity as long as the bonds have the same bond rating? Can you think of any real-world factors which might make a given investor prefer one of these bonds over the other?

Answer 1

1]

Liquidity risk arises in bonds that are thinly traded. Their volumes are low in the bond markets. Thus, investing in such a bond results in the risk that the current market price may not be the actual price realized if the bond is sold. This is because due to low volumes, the bid-ask spread will be high, and the sale of the bond may not be executed at the last traded price. This may result in a lower realized value from the sale of the bond.

Liquidity risk increases the bond yield, as the bond investors require a higher yield for investing in riskier bonds.

Default risk is the risk that the bond issuer may not make the interest and principal payments on time, or may not make them at all. Bonds issued by any issuer other than the Treasury have default risk. The default risk is higher for low rated bonds than high rated bonds.

Default risk increases the bond yield, as the bond investors require a higher yield for investing in riskier bonds.

Taxability risk is the risk that the tax rules may change in such a way that interest which is currently not taxed, or taxed at a lower rate, may become taxable, or taxable at a higher rate in the future. This risk also increases the bond yield.