How to Determine Risk Premium on Bonds

Be aware of factors that can influence bond values.
Be aware of factors that can influence bond values. (Image: Images)

Determining the risk of bonds is really an examination of three different risks. The first risk is credit risk, or the risk of default or credit downgrade. The second risk is that of interest rate risk, or the effect on the fixed income security if the general level of interest rates rise or fall. The third risk is that of early redemption, or premature repayment of all principal and interest.

Things You'll Need

  • Spreadsheet program
  • Bond yield calculator

Measure credit risk through careful analysis. Go to libraries or Internet resources where credit ratings on bonds are publicly available. Review major credit ratings to study the risk of default. Know that delay or total loss of future interest payments and repayment of the principal will impair a bond's value. Review credit ratings regularly as ratings do not measure risk for the life of the bond, but only the issuer's current ability to pay.

Measure credit risk by subtracting the yield of the bond under consideration for purchase versus a U.S. Treasury security of the same maturity. For example, presume a 10-year General Electric bond is worth 6 percent and a U.S. Treasury bond is at 5 percent. The risk premium is 1 percent. This difference is the credit quality as perceived in the marketplace. Credit spreads improve as confidence in the economy improves.

Compute interest rate risk as a function of bond maturity or duration. Use sophisticated computer programs to calculate risk. Choose long maturity bonds for greatest volatility. The longer the maturity period, the more the price of a bond is affected by variations in interest rates. For example, a 1 percent rise in a two-year bond results in a decline of value of 2 percent. The same rate rise of a 30-year bond results in a 10 percent decline in value.

Measure interest rate risk by studying historical records kept by government agencies. Note that in times of recession, short-term rates may decline several percentage points and long rates generally fall much less. Compare times when credit is scarce. Note that short and long rates rise -- the greater rise comes in short rates. Observe how in periods of low rates issuers attempt to refinance their outstanding debt at lower interest rates by invoking early redemption clauses.

Redeem bonds to gain interest rate advantages. Early redemption means that a bond purchased during a period of high interest rates will be immediately redeemed by repayment of the original borrowed amount plus interest and a small call premium. Understand that the result is the bond holder can no longer reinvest their monies at the more attractive interest rate. Remember, call features benefit the issuer not the bondholder.

Tips & Warnings

  • Know the call feature and the maturity yield when considering a bond purchase.
  • Know the general rate of interest among various maturities and credits. This is called the term level of interest rates.
  • Don't buy bonds past 10 years as interest rate risk and early redemption risk rise with little additional reward in the form of higher yields.

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