2.4 Bond Features & Risks
Bond investments carry multiple distinct risks: interest rate risk, reinvestment risk, call risk, inflation risk, and credit risk. Managing these risks requires matching investor horizons with bond duration.
Key FINRA Exam Takeaways
- Call feature: Favors the ISSUER. Exercised when interest rates DROP to refinance at lower rates (call risk).
- Put feature: Favors the INVESTOR. Exercised when interest rates RISE to redeem at par.
- Interest rate risk: Bond prices drop as interest rates rise. Longer maturity and lower coupon = greater duration and volatility.
- Zero-coupon bonds have the HIGHEST interest rate risk (duration equals maturity).
- Credit/Default risk: Evaluated by S&P, Moody's, and Fitch. Investment grade is BBB- / Baa3 or higher.
Duration and Volatility Rules
Rule 1: Long-term bonds fluctuate more in price than short-term bonds when interest rates change. Rule 2: Low-coupon bonds fluctuate more than high-coupon bonds. Rule 3: Zero-coupon bonds are the most volatile because they have no intermediate cash flows.
Call Protection and Refunding
Call protection prevents the issuer from calling the bond during its first several years (e.g., 5 or 10 years). Refunding occurs when an issuer sells a new bond at lower interest rates to redeem high-coupon existing debt.
Interest rates are projected to rise significantly over the next two years. An investor holding which of the following bonds will experience the GREATEST price decline?