Learning outcomes

After this video, you will be able to identify

the main risks that you are exposed to when

you hold government bonds in your portfolio.

Stay tuned for later videos in this

specialization to know how to hedge

yourselves from these risks.

Introduction

After reviewing the benefits of investing

in government bonds …

…we will now focus on the risks involved

in doing so

… and get some first insights as to how to

avoid these risks.

Risks

Economic risk

Political risk

Interest rate risk

Inflation risk

Currency risk

Economical risk

Economic risk

While a country rarely defaults, it can still happen.

When times are tough for a country’s economy, the

income from taxes is reduced while the government

still has expenditures and bondholders to pay.

In theory, a country can always raise taxes to finance

its debt.

Economic risk

However, investors recognize when a country’s economy is in bad

shape and ask for higher interest rates!

As you now know, a rise in interest rates causes the price of

existing bonds to fall!

Due to this increase in its debt burden, the government may have to

default or restructure its debt resulting in a non-payment or partial

payment of the money that is owed to bondholders (coupons and

capital).

Political risk

Political risk

There is also the possibility that a government

refuses to pay its debt despite being able to do so!

This can happen when the country’s political

situation is unstable.

In such cases, a new government might choose

not to pay back its creditors.

Political risk

Note that a government has a strong incentive not

to default.

Indeed, when it will eventually need money to finance

its activities, investors will be reluctant to lend money

which means they will ask for high interest rates!

Interest rate risk

Interest rate risk

Last year, you bought a 3-year bond at par for 100$ with a yearly

coupon of 10$.

Today, the government decides to issue a new series of 2-year

bond.

Given the current economic outlook, the government issues these

bonds at a price of 100$ with a coupon of 12$.

The price of your bond will decrease so that its yield to maturity is

equal to 12%.

Interest rate risk

The issuance of new bonds with a different coupon

rate than your bond will affect its price.

Indeed, your bond may be more or less valuable

than before given the yield of the new bonds that

are now available to investors.

Interest rate risk is captured by…the duration of a bond

(Approximate) percent change in the price of a bond

=

where

𝑫 is the duration

∆𝒓 is the change in interest rate

𝒓 is the prevailing interest rate

How interest rates impact bond prices

Assume

𝑫 = 6.55

At the current interest rate of 10%, the price of the bond is

100$.

𝒓 increases from 10% to 12%.

The approximate percent change in the price of the bond will be:

−6.55 ×0.02

1 + 0.1× 100 = −11.91

Inflation risk

Inflation risk

One of the merits of bonds is their regular revenue stream that

is known in advance.

As it turns out, this fixed characteristic can be the source of

one of their risk as well.

Suppose you hold a bond that gives you 100$ each year as

coupon for the next 10 years.

Inflation risk

Now, after three years, the price of the goods that people

traditionally consume increases.

This general increase in the prices of goods was not expected

when you bought the bond!

Thus, it is “unexpected inflation”.

So, things you need to buy now cost more but you still get the

fixed coupon of 100$ a year.

Inflation risk

As a consequence, the government will have to increase

interest rates so that new bonds remain attractive to investors

by providing an adequate purchasing power.

Thus, the price of your bond will decrease as we have

seen before.

Currency risk

Currency risk

Government bonds are traditionally issued in domestic

currency.

As a foreign investor, the purchasing power you

receive from such bonds depends on the exchange rate

between the currency in which the bond is issued

and the currency you use to buy goods.

Conclusions

Despite traditionally being among the safest assets,

government bonds bear some risks.

Some can be mitigated through careful analysis.

Others be hedged, as you will discover later in the

specialization…