Lower-grade municipal bond price risk and sensitivity of price volatility to level of yields

Abstract

Price volatility (variance) is a common measure of bond risk. Previous analysis has shown price volatility to depend upon duration and the volatility of interest rates. A more complete and accurate second-order model shows that price volatility also depends on predicted changes in yield and convexity. Municipal bond price volatility estimated by the more accurate second-order model can be much larger (200 per cent) than estimated first-order volatility. Analysts using only a first-order model can make large errors. Additionally, the effect of yield level on price volatility can be very different in first and second-order models.