Understanding Key Bond & Interest Rate Concepts

Hello everyone!
Today, let’s explore some important concepts related to Interest Rate Derivatives (IRD) and bonds. These topics often appear in study material and exams, so it’s useful to break them down in a structured way.

1. Credit Risk in Bonds

Question: Which of the following has a higher credit risk: AAA, AA, A, or BBB rated bonds?

• AAA-rated bonds → Considered the safest.
• AA-rated bonds → Slightly riskier than AAA, but still very safe
• A-rated bonds → Carry more risk compared to AA.
• BBB-rated bonds → Riskier than AAA, AA, and A.

👉 Answer: BBB-rated bonds have the highest credit risk among the given options.

2. Understanding Credit Spread

Credit Spread is the extra yield (return) that investors demand for holding a corporate bond compared to a government bond.

• Example:
• Government bond yield: 6% (risk-free).
• Corporate bond yield: 7.5% (riskier).
• Credit Spread = 7.5% – 6% = 1.5%.

This spread exists because corporate bonds carry default risk. Investors need compensation for the possibility that the company might fail to repay.

👉 Government bonds are safer as governments can print money to pay obligations, while companies may default.

3. Term Structure of Interest Rates

The term structure shows the relationship between short-term and long-term interest rates.

• Example:
• Short-term rate = 8%
• Long-term rate = 10%

This indicates a normal or positive yield curve.

Why? Because:

• Short-term = Lower risk, lower return.
• Long-term = Higher uncertainty, so investors demand higher returns.

👉 A normal yield curve slopes upward, showing that long-term rates are higher than short-term rates.

4. Accrued Interest

Accrued Interest is the interest that has accumulated between two coupon payment dates.

• Applies to: Coupon-paying bonds.
• Does not apply to: Zero-coupon bonds.

Example:

• Bond face value = ₹1000
• Coupon rate = 10% (₹100 annually)
• If the bond is sold in June (halfway through the year), the buyer must pay the seller 6 months’ accrued interest (₹50), since the seller held the bond during that period.

👉 Zero-coupon bonds don’t pay interest in between. They are issued at a discount and redeemed at face value.

5. Modified Duration

Modified Duration measures how sensitive a bond’s price is to interest rate changes.

• When interest rates rise → Bond prices fall.
• When interest rates fall → Bond prices rise.

Impact of Coupon on Duration:

• Higher coupon bonds → Shorter duration (investors recover money sooner).
• Lower coupon bonds → Longer duration (investors wait longer to recover money).

Example:

• Bond A: 10% coupon (₹100 annually). Investor recovers capital faster.
• Bond B: 6% coupon (₹60 annually). Investor recovers capital slower.

👉 Therefore, higher coupon = lower modified duration.

📌 Key Takeaways

1. BBB bonds carry the highest credit risk compared to AAA, AA, and A.
2. Credit spread compensates investors for taking on default risk in corporate bonds.
3. A normal yield curve means long-term rates are higher than short-term rates.
4. Accrued interest applies only to coupon-paying bonds, not zero-coupon bonds.
5. Modified duration decreases when the coupon rate increases.