Thursday, March 10, 2011

risk free bond isn't risk-free

(Thanks to Eric for the enlightenment.)

Risk free treasury is credit-risk free, but not rate-risk free.

If you buy a large quantity of 30-year long bond at $99 and hold it till maturity, and valuation drops steadily from $99 to $98, $97... then your balance sheet will reflect an unrealized loss every year, a large loss if the position is large.

Many people actually looks at your balance sheet. So this large unrealized loss will affect your company's financial health.

If you use this bond as collateral, the depreciation will affect its collateral value. If you borrow money using this collateral and lender demands additional collateral due to depreciation, this risk-free bond could make you bankrupt.

Compared to equities, risk-free bonds won't lose the entire value. You will get back the face value if you hold it to maturity, but your investment has a poor return relative to the prevailing interest rates available on the market. Suppose your coupon is 100bps, but interest rate moves up after your purchase. If you don't liquidate the losing position, you would keep earning the 100bps while other long-term investments would have fetched 200bps returns.

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