factors affecting bond sensitivity to IR

In this context, we are concerned with the current market value (eg a $9bn bond) and how this holding may devalue due to Rising interest rate for that particular maturity.

* lower (zero) coupon bonds are more sensitive. More of the cash flow occurs in the distant future, therefore subject to more discounting.

* longer bonds are more sensitive. More of the cashflow is “pushed” to the distant future.

* lower yield bonds are more sensitive. On the Price/yield curve, at the left side, the curve is steeper.

(I read the above on a slide by Investment Analytics.)

Note if we hold the bond to maturity, then the dollar value received on maturity is completely deterministic i.e. known in advance, so why worry about “sensitivity”? There are 3 issues with this strategy:

1) if in the interim my bond’s MV drops badly, then this asset offers poor liquidity. I won’t have the flexibility to get contingency cash out of this asset.

1b) Let’s ignore credit risk in the bond itself. If this is a huge position (like $9bn) in the portfolio of a big organization (even for a sovereign fund), a MV drop could threaten the organization’s balance sheet, credit rating and borrowing cost. Put yourself in the shoes of a creditor. Fundamentally, the market and the creditors need to be assured that this borrower could safely liquidity part of this bond asset to meet contingent obligations.

Imagine Citi is a creditor to MTA, and MTA holds a bond. Fundamental risk to the creditor (Citi) — the borrower (MTA)  i.e. the bond holder could become insolvent before bond maturity, when the bond price recovers.

2) over a long horizon like 30Y, that fixed dollar amount may suffer unexpected inflation (devaluation). I feel this issue tends to affect any long-horizon investment.

3) if in the near future interest rises sharply (hurting my MV), that means there are better ways to invest my $9bn.


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