Independence of Bond Risk Factors

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Independence of Bond Risk Factors

Postby Call_Me_Op » Sat Jun 29, 2013 5:49 pm

Something has been bugging me for the past couple of days and I just figured out what it is - and it has prompted this post.

The two principal risk factors that cause prices of bonds to vary are interest rate risk and credit risk. Most discussions I have seen on this topic tend to treat these two risk factors as independent - but yet at some level they seem inextricably linked. They seem linked because if a bond suffers a downgrade in credit rating (for example), its price will drop and its interest rate (interest divided by bond value) will increase. In other words, interest rate risk and credit risk both result in fluctuation in bond interest rates.

It seems that the way to think about this is to assume that treasuries have zero credit risk, and all changes in treasury prices are due only to interest rate risk. Then any change in spread between a given non-treasury bond and a treasury of the same maturity can be attributed to credit risk. In that way, it seems that the two factors can be considered independent. So the factors are independent if properly defined. Does this make sense?
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Re: Independence of Bond Risk Factors

Postby linuxizer » Sat Jun 29, 2013 8:02 pm

That's exactly how academics define the two. See Fabozzi, or the wiki should say that somewhere.
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Re: Independence of Bond Risk Factors

Postby ogd » Sat Jun 29, 2013 8:07 pm

Yup. Note that there are other risk factors that manifest as yield increases, for example taxation changes on munis would affect the spread between munis and Treasuries.
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Re: Independence of Bond Risk Factors

Postby Kevin M » Sat Jun 29, 2013 8:19 pm

Yes, I consider them two distinct risk factors. But, they manifest in the same way--as changes in price and yield.

A general increase in the cost of money (interest rates) will be accompanied by a price change in treasuries and corporates (you can think of either price or interest rate as the driver; they are simply two ways to view the same thing). Credit issues, e.g., defaults, also will be reflected as price and yield change in the affected bonds. The spread between treasury and corporate rates indicate the perceived credit risk in the corporate bonds being considered.

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Re: Independence of Bond Risk Factors

Postby MCSquared » Sun Jun 30, 2013 2:10 pm

Kevin M wrote:Yes, I consider them two distinct risk factors. But, they manifest in the same way--as changes in price and yield.

A general increase in the cost of money (interest rates) will be accompanied by a price change in treasuries and corporates (you can think of either price or interest rate as the driver; they are simply two ways to view the same thing). Credit issues, e.g., defaults, also will be reflected as price and yield change in the affected bonds. The spread between treasury and corporate rates indicate the perceived credit risk in the corporate bonds being considered.

Kevin


What about the 200-300 bips spread we saw between Treasuries and FDIC guaranteed bank debt a few years ago? Did that indicate the perceived credit risk of the FDIC guarantee versus the Treasury?
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Re: Independence of Bond Risk Factors

Postby Call_Me_Op » Sun Jun 30, 2013 2:15 pm

MCSquared wrote:
Kevin M wrote:Yes, I consider them two distinct risk factors. But, they manifest in the same way--as changes in price and yield.

A general increase in the cost of money (interest rates) will be accompanied by a price change in treasuries and corporates (you can think of either price or interest rate as the driver; they are simply two ways to view the same thing). Credit issues, e.g., defaults, also will be reflected as price and yield change in the affected bonds. The spread between treasury and corporate rates indicate the perceived credit risk in the corporate bonds being considered.

Kevin


What about the 200-300 bips spread we saw between Treasuries and FDIC guaranteed bank debt a few years ago? Did that indicate the perceived credit risk of the FDIC guarantee versus the Treasury?


I would say "yes" - for the short time period that this large spread existed. Remember that there was a fear of deflation at the time, and the FDIC does not guarantee future interest in the case of bank failure. This is a huge advantage for long-dated treasuries in a deflationary environment.
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Re: Independence of Bond Risk Factors

Postby Kevin M » Sun Jun 30, 2013 2:27 pm

MCSquared wrote:What about the 200-300 bips spread we saw between Treasuries and FDIC guaranteed bank debt a few years ago? Did that indicate the perceived credit risk of the FDIC guarantee versus the Treasury?

Perhaps. I don't actually remember that (that was the least of my worries then), but if it did happen, then perhaps it had something to do with the fact that large investors (institutions, governments) can't take much advantage of FDIC insurance.

Let's turn it around. Why can you earn almost 1% in an FDIC insured savings account when T-bills are yielding a small fraction of that? Why were good 5-year CDs earning about twice that of 5-year treasuries a month ago?

I think there are very different forces at work in these two markets.

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Re: Independence of Bond Risk Factors

Postby MCSquared » Sun Jun 30, 2013 2:32 pm

Call_Me_Op wrote:
MCSquared wrote:
Kevin M wrote:Yes, I consider them two distinct risk factors. But, they manifest in the same way--as changes in price and yield.

A general increase in the cost of money (interest rates) will be accompanied by a price change in treasuries and corporates (you can think of either price or interest rate as the driver; they are simply two ways to view the same thing). Credit issues, e.g., defaults, also will be reflected as price and yield change in the affected bonds. The spread between treasury and corporate rates indicate the perceived credit risk in the corporate bonds being considered.

Kevin


What about the 200-300 bips spread we saw between Treasuries and FDIC guaranteed bank debt a few years ago? Did that indicate the perceived credit risk of the FDIC guarantee versus the Treasury?


I would say "yes" - for the short time period that this large spread existed. Remember that there was a fear of deflation at the time, and the FDIC does not guarantee future interest in the case of bank failure. This is a huge advantage for long-dated treasuries in a deflationary environment.


Op, IMO I don't think the spread had anything to do with future interest in case of bank failure. This was bank senior issued debt that was directly guaranteed by the FDIC under the Temporary Liquidity Guarantee Program. This FDIC guarantee was for the timely payment of principal and interest.
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Re: Independence of Bond Risk Factors

Postby MCSquared » Sun Jun 30, 2013 2:41 pm

Kevin M wrote:
MCSquared wrote:What about the 200-300 bips spread we saw between Treasuries and FDIC guaranteed bank debt a few years ago? Did that indicate the perceived credit risk of the FDIC guarantee versus the Treasury?

Perhaps. I don't actually remember that (that was the least of my worries then), but if it did happen, then perhaps it had something to do with the fact that large investors (institutions, governments) can't take much advantage of FDIC insurance.

Let's turn it around. Why can you earn almost 1% in an FDIC insured savings account when T-bills are yielding a small fraction of that? Why were good 5-year CDs earning about twice that of 5-year treasuries a month ago?

I think there are very different forces at work in these two markets.

Kevin


I am not sure what you mean when you say that institutions couldn't take advantage of FDIC insurance? These bonds were owned and traded by institutions. It seems they traded wider than treasuries as the market obviously assessed them as being riskier credit wise.
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Re: Independence of Bond Risk Factors

Postby Call_Me_Op » Sun Jun 30, 2013 5:52 pm

MCSquared wrote:
Call_Me_Op wrote:
MCSquared wrote:
Kevin M wrote:Yes, I consider them two distinct risk factors. But, they manifest in the same way--as changes in price and yield.

A general increase in the cost of money (interest rates) will be accompanied by a price change in treasuries and corporates (you can think of either price or interest rate as the driver; they are simply two ways to view the same thing). Credit issues, e.g., defaults, also will be reflected as price and yield change in the affected bonds. The spread between treasury and corporate rates indicate the perceived credit risk in the corporate bonds being considered.

Kevin


What about the 200-300 bips spread we saw between Treasuries and FDIC guaranteed bank debt a few years ago? Did that indicate the perceived credit risk of the FDIC guarantee versus the Treasury?


I would say "yes" - for the short time period that this large spread existed. Remember that there was a fear of deflation at the time, and the FDIC does not guarantee future interest in the case of bank failure. This is a huge advantage for long-dated treasuries in a deflationary environment.


Op, IMO I don't think the spread had anything to do with future interest in case of bank failure. This was bank senior issued debt that was directly guaranteed by the FDIC under the Temporary Liquidity Guarantee Program. This FDIC guarantee was for the timely payment of principal and interest.


Oh, I thought you were referring to CD's.
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Re: Independence of Bond Risk Factors

Postby Kevin M » Sun Jun 30, 2013 7:56 pm

Call_Me_Op wrote:Oh, I thought you were referring to CD's.

Me too (and other retail FDIC-insured products, like savings accounts). At any rate, isn't this off topic? It's just a tangential discussion about one of the risk factors raised in the OP.

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Re: Independence of Bond Risk Factors

Postby MCSquared » Sun Jun 30, 2013 9:54 pm

Kevin M wrote:
Call_Me_Op wrote:Oh, I thought you were referring to CD's.

Me too (and other retail FDIC-insured products, like savings accounts). At any rate, isn't this off topic? It's just a tangential discussion about one of the risk factors raised in the OP.

Kevin



Why is it off topic? Here is an excerpt from the original topic post (my bold),

"It seems that the way to think about this is to assume that treasuries have zero credit risk, and all changes in treasury prices are due only to interest rate risk. Then any change in spread between a given non-treasury bond and a treasury of the same maturity can be attributed to credit risk. In that way, it seems that the two factors can be considered independent. So the factors are independent if properly defined. Does this make sense?"

Assuming one believe's that CD's have the same credit risk (zero) as UST, how does one explain the difference in pricing if the credit risk for FDIC guaranteed debt was/is the same as UST? Are there other independent risk factors at play?
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Re: Independence of Bond Risk Factors

Postby Kevin M » Sun Jun 30, 2013 11:32 pm

OK, I see your point about how it is related to the OP.

I don't know about when FDIC-insured products were yielding less than treasuries, but I'm not sure a separate risk factor generally explains why they currently are yielding more. I still think it's more a supply and demand thing: there simply is not enough supply of FDIC insurance, with the $250K limit, to meet the demand of large investors, so that demand/supply determines the price of treasuries. It's the demand/supply of smaller, retail investors and banks/CUs that affects CDs and other FDIC-insured products.

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Re: Independence of Bond Risk Factors

Postby Call_Me_Op » Mon Jul 01, 2013 9:00 am

Note that in my original post I wrote: "The two principal risk factors that cause prices of bonds to vary are interest rate risk and credit risk." The key word is principal. That means there are other factors, and supply/demand can be included there.
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Re: Independence of Bond Risk Factors

Postby Kevin M » Mon Jul 01, 2013 2:39 pm

I wasn't proposing that supply/demand is a risk factor; it's the mechanism that sets price within a market. The markets for treasuries and bank/CU CDs (normally) are different, so different supply and demand factors are at play.

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