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

By | 2013-10-08T10:40:50+00:00 October 8th, 2013|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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