Bond Price Dynamics & Investment Risks

Posted on Aug 9, 2025 in International Business Economics

Accretion (Pull to Par)

If the YTM does not change between the time the bond is purchased and the maturity date, what will happen to the price of the bond? For a bond selling at par value, where the coupon rate is equal to the required yield, as the bond moves closer to maturity, the bond will continue to sell at par value. Its price will remain constant as the bond moves toward the maturity date.

But the price of a bond will not remain constant for bonds selling at a premium or a discount. A discount bond increases in price (accretes) as it approaches maturity, assuming the required yield does not change. For a premium bond, the opposite occurs; this is called amortization. For both types of bonds, the price will equal par value at the maturity date.

The change in a bond’s market price will then be the result of a combination of changes in prevailing yields and the Pull to Par effect.

Rolling Down (or Up) the Curve

In the previous section, we assumed a constant yield to maturity over time. However, in reality, bond yields are not constant; they sit on a yield curve that is, more often than not, upward sloping.

In this context, roll-down is a statement about the capital appreciation or depreciation on a bond, assuming that the shape of the yield curve doesn’t change. For example, consider the yield curve below (for simplicity, assume it’s for zero-coupon bonds).

Let’s assume that on Day 1, we buy a zero-coupon 5-year bond. The yield of that five-year bond is 4.08%, so its price is 100 / (1.0408)5 = $81.88.

Now, in a year’s time, assuming the yield curve’s shape is unchanged, that bond will be a four-year bond.

…with a yield of 3.7%, so its price will be 100 / (1.037)4 = $86.47.

Therefore, the rate of return from holding the bond for one year, assuming its yield doesn’t change, is:

R = (86.47 / 81.88) – 1 = 5.60%

Note that this is higher than the bond’s original yield of 4.08%. The difference between the bond’s original yield to maturity and the expected return (assuming no change in the yield curve) is the roll-down. In this case, the roll-down is:

5.60% – 4.08% = 1.52%

Thus, the roll-down can be a very significant contributor to a bond’s return, especially in environments with steep yield curves and low yield volatility.

Likewise, if the yield curve were to have an inverted shape, the roll-up effect would generate a negative return.

Recap of Bond Price Movements

Here is a summary of all the factors that can make benchmark bond prices change:

  1. Changes in market yields
  2. Pull to Par effect
  3. Roll the curve effect

Specifically for credit bonds (Credit risk is reviewed in Part 2 of the Notes):

  1. Change in yields of a credit because of a change in its credit condition (improvement or deterioration) → change in the credit spread

Bond Investment Risks

  • Interest Rate/Market Risk – The risk that the bond’s price will fluctuate with changes in interest rates of the same class. This is mostly related to benchmark (risk-free) bonds.
  • Credit Risk – The risk that the bond’s price will fluctuate with changes in its credit quality.
  • Liquidity Risk – The risk that the bond’s price will fluctuate with changes in its liquidity (e.g., widening of the bid-offer spread).
  • Reinvestment Risk – The risk that coupons are not reinvested at the originally contracted yield to maturity (YTM). Relevant only for coupon bonds with fixed maturity.

Liquidity is difficult to assess unless you’re actively in the market.

Reinvestment risk increases with higher coupons; the higher the coupon, the more challenging it is to reinvest it at a rate at least as good as the coupon itself.

Risk-Free Coupon Government Bonds (Benchmarks)

  • USD: UST
  • EUR: German GB
  • YEN: JGB
  • GBP: GILT
  • Interest Rate Risk: Main risk.
  • Credit Risk: Not relevant/applicable, as these are credit risk-free benchmarks.
  • Liquidity: Most government bonds in these benchmarks are very liquid, so this risk is generally not relevant.
  • Reinvestment Risk: Can be very relevant, especially if their coupons are high.

Fixed Coupon Bonds with a Credit Component

The prevalent risk here will depend on the bond’s credit quality.

  • The higher the credit quality, the more the bond will behave like a benchmark (i.e., interest rate risk prevails).
  • The lower the credit quality, the more the bond will fluctuate with changes in its credit quality and be less affected by changes in the benchmark. Sometimes, but not necessarily, it could also influence liquidity.

Examples:

  • AA-rated USD 20-year fixed coupon: Interest rate risk prevails. Other risks?
  • B-rated USD 5-year fixed coupon: Credit risk prevails. Other risks?

Zero-Coupon Benchmarks (e.g., STRIPS in USA)

  • Same as Coupon Benchmarks, except there is no reinvestment risk.

Floating Rate Bonds (FRNs)

  • Most FRNs have a credit component. Governments typically do not issue floaters, with the exception of inflation-adjusted bonds.
  • Interest rate risk will probably be less relevant. However, consider an A-rated FRN that resets its coupon every 5 years. The duration of that bond will be close to 5 years, so interest rate risk is present.

TIPS (Inflation-Adjusted Bonds)

  • TIPS are U.S. Treasury Bonds.
  • Credit and Liquidity Risk are not applicable.
  • Interest rate risk: There is some basis risk when interest rates surge for reasons other than inflation. In such cases, TIPS will not adjust, and investors may incur losses.

Callable Bonds

  • The bond’s structure (fixed vs. floater) and credit risk prevail.
  • However, there is an added risk: Call Risk.
  • The call is an option the investor sells to the issuer. This option carries the risk that the issuer will call the bond (redeem it at par) before maturity.

Securitizations

  • Credit risk is enhanced by the provision of collateral.
  • The value of the collateral matters and is “added” to the “full faith and credit” capacity of the issuer.
  • If the bond is rated, the assessment of the collateral’s true value will be contemplated in the rating.
  • Bond ratings are linked to the degree of collateralization of the structure.
  • If the bond is unrated, the investor will need to perform due diligence.

Contingent Convertibles (CoCos)

  • It’s primarily about credit risk.
  • Interest rate risk is negligible, as yields are much higher than senior fixed-coupon debt.