[MUSIC PLAYING] Now that we've established a method for measuring the value of bonds through the yield to maturity, let's wrap up the unit on bonds with a final look at the risks.
The first type of risk is the interest rate risk. And this risk is the uncertainty associated with changes in the price of a bond caused by changes in the general interest rate levels in the economy.
Since coupon payments are fixed, if general interest rates fall, bond prices increase. If interest rates rise, bond prices fall.
But if the bond holder is holding the bond to maturity, he is insulated from this interest rate risk. Here's an example. If he is holding a bond paying a 6% coupon and general interest rates fall, he'll continue to receive this 6% coupon payments.
What if interest rates rise? He may have opportunities to invest at a higher rate. But as long as he holds the bond at 6%, that's the return he'll receive.
The other side of the coin is reinvestment risk. Reinvestment risk is the uncertainty that the holder will be able to reinvest the funds at the same rate or a better rate at maturity. If the bond is callable and interest rates fall, it is more likely that the issuer will call the bond while the holder is enjoying the higher fixed coupon payment.
This shows us that reinvestment rate risk and interest rate risk are inversely related. An investor could moderate one or the other of these risks, but they can't eliminate both.
The third type of risk is the default risk. If you recall, this is the risk that the bond issuer will not make payments as scheduled. If payments are missed and it goes bankrupt, investors may lose much, if not all, of their money. In bankruptcy, bank lenders are very high in the precedents of being paid back from the liquidation.
Bond holders have precedence over equity holders and have a certain amount of legal protection. If a company goes bankrupt, its bondholders will often received some money back. The company's common stockholders usually end up with nothing.
When a company can't pay its obligation, it enters bankruptcy court. There are two types of bankruptcy for which a corporation can file.
One is chapter 11. In chapter 11 bankruptcy code, the business remains intact and in control of management. But it's subject to the oversight of the court.
In chapter 7, the company stops operating. The trustee of the court sells all the assets and then distributes the proceeds to the creditors.
Let's take a last look at these types of risk. Interest rate risk is the uncertainty of the impact of general economic rate changes on the price of a bond. If rates fall, the bond holder can still enjoy the higher coupon payment rate.
Reinvestment rate risk is the uncertainty that the bond holder won't be able to reinvest funds at the same rate. This could be encountered when rates fall or conditions when callable bonds are likely to be redeemed.
And finally there is default risk, which reflects the possibility that the issuer will not make coupon or maturity payments as scheduled.
This is Dr. Bob Nolley. And I'll see you in the next lesson.