Bond Market Math (Part 4)

What is structural risk?

With bonds, duration risk and credit risk are easy to understand. Duration risk comes from extending time to maturity, and the additional interest paid compensates investors for the possibility that inflation rises. Credit risk is the chance that the issuer defaults and the investor doesn’t get paid.

But structural risk has to do with options. If the borrower has the right but not the obligation to do something, we say they have an option. The simplest option is a callable bond. When borrowers issue bonds, they have to pay interest on those bonds until they mature. When borrowers issue callable bonds, they have the right to pay those bonds off early at a certain “call” date. They do that if rates fall and they can save money.

Investors get paid something for taking this prepayment risk—for “writing” this option. The key to profiting from writing options is understanding that they have a certain time when they can be exercised. Investors want to write options that expire worthless. That way they get paid for something that doesn’t happen.

Lots of bonds have options: corporate bonds, agency bonds, mortgage bonds. If they understand how and when to write them, investors can appear to get “money for nothing” (and write calls for free).

Douglas R. Tengdin, CFA

Chief Investment Officer

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