Reading 62: Risks Associated with Investing in Bonds-LOS m 习 2011, investment, concerned, investor, center

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Session 15: Fixed Income: Basic Concepts
Reading 62: Risks Associated with Investing in Bonds

LOS m: Explain inflation risk.

 

 

David Korotkin, CFA and a broker at an investment bank, has a client who is very concerned about maintaining purchasing power over the next year. The investor is conservative, and to date has been pleased with a consistent return of 8.00%. The bank’s research department has estimated next year’s inflation rate at 2.0%. The client specifically wants to invest in a fixed-coupon bond. Which of the following statements is most correct? If Korotkin purchases a bond with a 10.00% coupon, the client:

A) may lose purchasing power.

B) will not lose purchasing power.

C) will realize a real gain.

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Investors want to be compensated for the inflation they expect plus for the risk that inflation will increase during the term of the investment. Here, the bank’s estimated inflation rate is just that – an estimate. Thus, we cannot say for certain that the investor will not lose purchasing power. Inflation risk introduces uncertainty to the investment process.

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Which of the following statements about inflation risk is NOT correct?

A) The short term inflation premium is less than the long term premium.

B) The real return on a fixed coupon bond is variable.

C) Treasury securities are considered immune to inflation and liquidity risk.

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The statement Treasury securities are considered immune to inflation and liquidity risk is partially true – Treasury securities are immune to liquidity risk, but fixed-coupon Treasury securities have high inflation risk and generally low real returns.

The other choices are correct. The inflation premium is less in the short term because investors are better able to predict inflation in the short term – inflation risk increases as time increases. (Investors want to be compensated for this uncertainty.) An investor’s real return is not fixed- even though an investor may hold a fixed-rate coupon bond, the real return depends on a variable – inflation. Higher inflation rates result in a reduction of the purchasing power of bond payments.

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Which of the following investors is least susceptible to inflation risk?

A) An individual with a 5 year certificate of deposit at a local financial institution.

B) A financial institution with assets concentrated in fixed-rate mortgages.

C) The holder of a 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25%.

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A 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25% is an example of a floating rate bond. The holder of an adjustable rate asset is impacted less by inflation than the holder of a fixed-rate asset because the increased cash flow (from the higher coupon payments when the base rate increases) at least partially offsets the decreased purchasing power caused by inflation.

The other two choices are examples of investors more susceptible to inflation - those who hold long-term contracts in which they are to receive a fixed payment.

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Which of the following investors faces the least inflation risk? An investor whose portfolio is concentrated in:

A) long-term treasury bonds.

B) equity securities.

C) fixed-rate certificates of deposit.

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Inflation risk refers to the possibility that prices of general goods and services will increase in the economy. Empirical evidence shows that equity securities, or stocks, have the least inflation risk of the investments listed here. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. Fixed-rate certificates of deposit have high inflation risk.

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One year ago, Makato Omura purchased a 6.50% fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4%. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the nominal return and that to calculate the real return, she needs to factor in the inflation rate over the holding period. If the price index for the current year is 118.5 and the price index one year ago was 115.9, Omura’s real return is closest to:

A) 9.6%.

B) 6.3%.

C) 5.2%.

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Omura’s real return is approximated by subtracting the inflation rate from the calculated (nominal) return. As indicated in the preliminary reading for Study Session 4, LOS 1.B.e, the inflation rate is calculated using the formula:

Inflation = (Price Index_{this year} – Price Index_{last year}) / Price Index_{last year}

Here, inflation = (118.5 – 115.9) / 115.9 = 0.0224, or approximately 2.2%.

Thus, the real return = 7.4% - 2.2% = 5.2%.