Measuring Risk

Few investments offer as objective an estimate of risk as bonds.

Because of some fixed characteristics - par (face value, repaid at maturity), coupon (interest rate, percentage paid in semi-annual payments on the par) and maturity (date principal is repaid) - predicting bond values and risk with some confidence is as much science as art.

First, a bit about bond prices and yields. Bond prices are quoted as a percentage of the bond's face value. For example, a bond trading at 102 is trading at a price 2% above it's par. For a $1000 bond, the quoted price would be 102, and the purchase price $1020. (For bonds in increments of $1000, simply add a zero at the end of the quote. Otherwise multiply the face value by the quote. E.g. $3,000 x .99 = $2970 on a bond selling 'at a discount' of 99.)

Next, observe that bond prices and yields move in opposite directions. When yields rise, prices fall. Common sense reveals the reason. A 5-year, 5% bond purchased today at $1000 will be worth less in a year if interest rates have generally risen to 6%, because new bonds can be purchased that pay higher interest payments.

Now, onto measuring risk.

Every bond carries some risk that the issuer will default on repayment of the principal, or suspend interest payments.

A bond's maturity period plays a large factor in determining that risk. The future 10 years on is less clearly predictable than that only a year hence. Interest rates, to which bonds are highly sensitive for reasons seen above, are less likely to change much over a year than over 10 years, and in much more predictable directions. They may be exactly the same 10 years from now, but almost certainly will have changed up and down in the interim. But how much and in what direction is harder to know, the longer the time frame.

On the other side of the ledger, issuers tend to compensate for that extra risk by offering higher rates on longer-term bonds, in order to attract investors.

One way to measure that risk is to calculate what a bond price is likely to be at some point in the future. Remarkably, this is done every day with a high degree of precision and probability.

To estimate the degree of a specific bond's price change should interest rates change, the bond market uses a measure known as duration. Duration is a weighted average of the present value of a bond's payments - semi-annual interest payments, as well as a large repayment at maturity.

'Present value' is a measure of the value today of expected money to be paid in the future. Think, for example, of the worth of loaning money to a neighbor. That money is a value today, but the expectation of re-payment plus interest tomorrow has a value too.

If you're tempted to believe that value is 'purely psychological', loan a large sum - say in the form of buying bonds - to a AAA company then go to the bank to borrow money. Those future interest payments are regarded as an asset by the bank. You could potentially borrow more for having the right to those coupon payments.

Calculating duration is a more technical affair than can be taken up here, but sample computations (as well as calculators to do it for you) are readily found on the Internet.

Duration calculations are unique to each bond but they allow comparisons between bonds with different maturities, coupons, and face values. Knowing it makes possible predictions of a bond's approximate price change in the event of, say, a 100 basis point (1/100 of a percent) change in interest rates.

For example, if general interest rates fall by one percent, yields on every bond in the market will fall by the same amount. Thus, the price of a bond with a duration of two years will rise two percent and the price of a five-year duration bond will rise five percent.

Despite the appearance of numerology, measuring risk quantitatively is carried out by analysts every day. Take advantage of their knowledge by using it to judge investment risk for your own portfolio.