Does a bonds yield = risk?

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drbagel
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Does a bonds yield = risk?

Post by drbagel » Mon Jan 11, 2010 4:02 pm

I have a question for anyone who understands bonds better than I.
Does the current yield of a bond or a bond fund represent a market estimate of risk? Would two bonds with different characteristics but the same yield have the same implied risk?

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mas
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Post by mas » Mon Jan 11, 2010 4:15 pm

A few reason that using only yield to asses risk could lead you astray...

Bonds have different types of risks:
* interest rate risk
* default risk

Taxation differs:
* Municipal bonds
* Treasuries
* other bonds

I'd say that with a group of bonds that has similar characteristics, that you could use the yield to determine the relative riskiness of each. But you couldn't compare a 10 yr muni vs a 5 yr corporate and expect the same.

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spam
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Re: Does a bonds yield = risk?

Post by spam » Mon Jan 11, 2010 5:04 pm

drbagel wrote
Would two bonds with different characteristics but the same yield have the same implied risk?
The problem with bonds is that they do not have a central clearing house like the NYSE where all bond offerings are represented simultaneously. The problem with risk is how to define it.

If you simply define a bonds risk by its credit rating then it is possible to find one A+ rated bond with a different yield at a different bond desk.

For practical purposes, I would say that the answer to your question is most often yes if you broadened the term yield to mean a small range of values.

eurowizard
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Post by eurowizard » Mon Jan 11, 2010 5:31 pm

If you compare two bonds with the same call option, same duration/maturity, same liquidity, then the interest rate, all else equal, is determined by risk.

In fact, the market prices bonds using this principle by comparing one bond to another based on the relative risk and then adds a higher or lower yield based on that.

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drbagel
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Post by drbagel » Tue Jan 12, 2010 11:51 am

Thanks all. The differences in tax treatment are something I hadn't considered. Using yield as a risk measure may present some interesting scenarios. For example, in case of an inverted yield curve, a 6 month t-bill may carry a higher implied risk (higher yield) than a 10 or 30 year treasury bond.

Valuethinker
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Re: Does a bonds yield = risk?

Post by Valuethinker » Tue Jan 12, 2010 12:46 pm

drbagel wrote:I have a question for anyone who understands bonds better than I.
Does the current yield of a bond or a bond fund represent a market estimate of risk? Would two bonds with different characteristics but the same yield have the same implied risk?
A better way of saying this is that the spread (in basis points 100bp = 1%) of a bond over the comparable government bond of the same maturity and currency, is largely a measure of risk.

Default risk
Repayment risk (mortgage backed bonds)
Extenstion risk (ditto)
Liquidity risk
Call risk (corporate bonds, often)
Fiscal risk (risk of a change in tax treatment) for muni bonds
inflation risk (unexpected inflation overcomes the interest earned)

Because assuming exactly the same coupon and maturity, the 2 bonds would have the same interest rate risk (except for the special risks of mortgage backed securities re repayment and extension, and the call risk of a corporate bond)

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