Bond trading is like dating. The attractiveness of what you have changes based on your options. If you’re a busker in the subway, you’ll put up with more nonsense from a significant other than you will have once you become a millionaire-globe-hopping rock star.
Similarly, the attractiveness of a particular bond depends on what else is out there. To put it another way, the value of a bond changes as the overall interest rate environment changes.
A return of 3% on a bond looks fine when the average rate for that maturity sits at 2%. However, in an environment when you can get 5% for the same amount of risk, those 3% bonds start to look bad. You might start ignoring their texts and removing their pictures from your Facebook page.
The rate-level risk describes this situation. It refers to the fact that bond values fluctuate based on the overall interest rate environment. You buy the 3% bond at at a time when it looks like a good investment, based on the return you can get elsewhere for similar risk. If that environment changes, however (if overall rates rise), suddenly that bond doesn't seem as valuable.
Fundamentally, rate-level risk refers to the risk to bond prices related to changes in the overall rate environment. So the risks don't have anything to do with that particular bond. The risks completely stem from the chances that something will change in the general market situation.
Related or Semi-related Video
Finance: What is call protection, and ho...2 Views
And finance Allah shmoop what is called protection and how
does it work So you wish this term was about
preventing those annoying telemarketers who call you right in the
middle of dinner hoping to sell you X and satellite
subscriptions But it's not Call protection has to do with
a bond being called early meaning that the company that
issued the bond I either company that borrowed the money
is paying at least full par value principle if not
a percent or two premium above that figure when they
call the bond So why would you want protection against
this happening Like isn't it a good thing that bonds
get called back by the people who borrow the money
and then get fully paid off Well the answer No
not always Let's say a bond is issued in a
high interest rate environment like the Fed is trying to
cool inflation so they have short term high interest rates
or high short term borrowing costs That calm six percent
for one year paper eight percent for five year paper
for the best borrowers and a bond you invested in
was yielding two hundred basis points above those U S
government bonds or in this case and say it's five
year paper That's a yielding ten percent But then inflation
cooled and the Fed suddenly lowered rates a lot and
that six percent paper a few years later pays only
four percent and that five year eight percent paper is
now down Teo five percent Well the company that issued
its bond paying ten percent interest could refinance that bond
today at only seven percent interest And they do Right
so they're saving three points of interest Unusually you know
like a billion dollars of Borrow They call the bonds
back home to the mother ship Yep they paid them
all off Maybe with say a two percent premium Big
Woop so that a thousand dollars par unit of the
bond gets one o two or a thousand twenty to
pay it off and retire it well thank you The
investor in that bond who thought you were getting ten
percent a year in interest for a while You can't
even find paper like that in the market The best
you can do of similar risk in duration is only
seven percent so you've lost three percent per year compounded
interest by having those lovely ten percent yielding Bonds called
its protection against this lost yield that bond holders want
and well that's how it works If you'd had bonds
that were uncool a ble or call pretty detected the
company couldn't just buy them back and refinance with cheaper
paper So yeah that's why it's always nice to have
your bonds protected and for even greater security we recommend 00:02:25.28 --> [endTime] investing in a Rottweiler
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