There are many risks when investing in bonds. Investors can minimize their negative exposures by knowing the risks involved in investing in bonds.
Following you can find the basic risk categories:
1. Interest Rate Risks
Interest rate risk is usually the major factor influencing a bond’s market price and total return.
The market prices of most bonds move in the opposite direction of a change in interest rates and if the general consensus among bond investors is that the rate of inflation will increase in the future, lowering the purchasing power of a given currency, then the investor will demand a higher return for investing in a bond.
The increase in the interest rate results in that newly issued bonds will pay higher interest rates to compensate for the investorsʼ expected loss of purchasing power.
The prices of bonds currently trading in the market will decrease, which effectively will increase the return to the prospective purchaser of the bond without changing the coupon payment.
Interest rate risk increases for bonds with longer maturities and lower coupon payments, and decreases for bonds with shorter maturities and higher coupon payments.
2. Reinvestment Risks
Reinvestment risk is related to interest rate risk, but has the opposite effect on a bond’s performance.
Reinvestment risk refers to the risk that the rate at which the coupons and the principal cash flows from a bond that are reinvested will be lower than the expected rate in effect when the bond was purchased.
If the expected interest rates decrease during the holding period of a bond, the value of the coupon increases, if it is paid at a fixed rate, while the reinvestment value of the coupon flows decreases, due to the lower market rates earned on the reinvested coupon.
Reinvestment risks increase for bonds with longer maturities and higher coupon payments, and decrease for bonds with shorter maturities and lower coupon rates.
3. Credit Risks
Credit risk is the risk that the issuer of a bond will be unable to make the coupon and principal payments specified for a given bond.
This risk is the risk that most investors focus on when purchasing bonds, but it usually has less of an effect on returns than some of the other risks, namely interest rate risk or call risk.
Credit risk is usually quantified by comparing a bond’s yield to that of a bond with a similar maturity and cash flows but with negligible credit risk, i.e., a Treasury security.
Credit risk is evaluated by major bond rating agencies, Standard & Poor’s, Moody’s, Duff & Phelps, Fitch, etc.
As the credit risks of a bond increase, any changes to that perceived credit risks tend to have an increased impact on a bond’s price.
The credit risks of high yields, or junk bonds, are significant and therefore a change in the credit quality of an issuer of high yield bonds will be apt to have a significant impact on the bonds of that issuer.
4. Call Risks
Many bonds have call features as part of their structures, and these call features represent another risk to the bondholders.
A bond with a call feature can be redeemed by the issuer prior to maturity at a specified price. In practice, most bonds with call features will be redeemed by the issuer when interest rates have dropped significantly and the issuer can refinance the debt at a lower cost.
Conditions that make call features valuable to the issuers make bonds with call features less desirable to investors.
Because of this, purchasers of callable bonds will typically demand a higher yield at purchase for callable bonds than for similar bonds without call features
All mortgage bonds have call features that are exercisable by the mortgage holders by refinancing. These call features are the main reasons that mortgage securities trade at a higher yield than comparable Treasury securities.
5. Liquidity Risks
Liquidity risk refers to the ease with which a bond can be purchased or sold. Bonds that trade frequently and in large amounts, such as Treasury securities, usually have less liquidity risk than bonds which trade less frequently.
Liquidity risk is usually indicated by the difference between the bid, or the price at which a market maker will purchase a security, and the offer, or the price at which a market maker will sell a security.
The difference between the bid and the offer prices represent the cost of trading the security, and the spread between the two reflects the market maker’s uncertainty as to the value of the security.
6. Inflation Risks
Inflation risk refers to the risk that the rate of inflation that is experienced by the investor will be higher than anticipated when the bond was purchased, resulting in reduced purchasing power.
This risk can be reduced through the use of adjustable rate bonds, whose coupon payments increase or decrease based on the level of a stated index.
7. Currency Risks
An investor is exposed to currency risk if a bond is denominated in a currency other than his home currency.
If the value of the currency in which the bond is denominated decreases in value relative to the investor’s home currency, the investor will receive smaller interest and principal payments than were expected.
The investor is also exposed to the interest rate risk and market risk that is present in the foreign country where the investment takes place.
8. Event Risks
Event risks refer to the possibilities that there may be events or circumstances that could have a major effect on the ability of an issuer to repay a bond obligation.
This could i.e. be an accident or a takeover or a major natural disaster or a sovereign debt crisis.