BUS202: Principles of Finance

Price risk is the risk that the market price of a bond will fall, usually due to a rise in the market interest rate.

TERM

• mutual funds

  A type of professionally-managed collective investment vehicle that pools money from many investors to purchase securities. While there is no legal definition, the term is most commonly applied only to those collective investment vehicles that are regulated, available to the general public and open-ended in nature.

Interest rates and bond prices carry an inverse relationship. Bond price risk is closely related to fluctuations in interest rates. Fixed-rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere — perhaps by purchasing a newly-issued bond that already features the new higher interest rate. On the flip side, if the prevailing interest rate were on the decline, investors would naturally buy bonds that pay lower rates of interest. This would force bond prices up.

Unless you plan to buy or sell them in the open market, changing interest rates do not affect the interest payments to the bondholder, so long-term investors who want a specific amount at the maturity date do not need to worry about price swings in their bonds and do not suffer from interest rate risk. However, because of the interest rate risk, bonds with longer terms are more risky than bonds with shorter terms.

Price changes in a bond will immediately affect mutual funds that hold these bonds. If the value of the bonds in their trading portfolio falls, the value of the portfolio also falls. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk could become a real problem.

Bond prices can become volatile depending on the credit rating of the issuer – for instance if the credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the credit rating of the issuer. An unanticipated downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.