What are Bond Risks?
Bonds as an investment tool are considered mostly safe. However, no investment is devoid of risks. In fact, investors who take greater risks accrue greater returns and vice versa. Investors averse to riskAverse To RiskThe term "risk-averse" refers to a person's unwillingness to take risks. Investors who prefer a low-return investment with known risks to a higher-return investment with unknown risks, for example, are risk-averse. feel unsettled during intermittent periods of slowdown while risk-loving investors take such incidents of a slowdown in a positive way with the expectation of gaining significant return over time. Hence, it becomes imperative for us to understand the various risks that are associated with bond investments and to what extent they can affect the returns.
Below is the list of most common types of Risks in Bond that investors should be aware of
- Inflation RiskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk.
- Interest Rate RiskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable.
- Call Risk
- Reinvestment RiskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity.
- Credit RiskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.
- Liquidity RiskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.
- Market Risk
- Default Risk
- Rating Risk
Now we will get into a little detail to understand how these risks manifest themselves in the bond environment and also how an investor can try to minimize the impact.
Top 9 types of Bond Risks
#1 – Inflation Risk/Purchasing Power Risk
Inflation risk refers to the effect of inflation on investments. When inflation rises, the purchasing power of bond returns (principal plus coupons) declines. The same amount of income will buy lesser goods. For e.g., when the inflation rate is 4%, every $1000 return from the bond investmentBond InvestmentBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. will be worth only $960.
#2 – Interest Rate Risk
Interest rate risk refers to the impact of the movement in interest rates on bond returns. As rates rise, bond price declines. In the event of rising rates, the attractiveness of existing bonds with lower returns declines, and hence the price of such bond falls. The reverse is also true. Short-term bonds are less exposed to this risk, while long term bonds have a very high probability of getting affected.
#3 – Call Risk
Call riskCall RiskCall risk is the uncertainty that arises when the investors purchase bonds but perceive that the issuer will redeem this debt instrument before its maturity date. Thus, resulting in the possibility that the investors would have to reinvest the disbursed amount at a much lower rate or in an unfavourable investing market scenario. is specifically associated with the bonds that come with an embedded call option. When market rates decline, callable bondCallable BondA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls. issuers often look to refinance their debt, thus calling back the bonds at the pre-specified call price. This often leaves the investors in the lurch who are forced to reinvest the bond proceeds at lower rates. Such investors are, however, compensated by high coupons. The call protection feature also protects the bond from being called for a particular time period giving investors some relief.
#4 – Reinvestment Risk
The probability that investors will not be able to reinvest the cash flows at a rate comparable to the bond’s current return refers to reinvestment risk. This tends to happen when market rates are lower than the bond’s coupon rate. Say, a $100 bond’s coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100% is 8% while the prevailing market rate is 4%. The $8 coupon earned will then be reinvested at 4%, rather than at 8%. This is called the risk of reinvestment.
#5 – Credit Risk
Credit risk results from the bond issuer’s inability to make timely payments to the lenders. This leads to interrupted cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. for the lender, where losses might range from moderate to severe. Credit history and capacity to repay are the two most important factors that can determine credit risk.
#6 – Liquidity Risk
Liquidity risk arises when bonds become difficult to liquidate in a narrow market with very few buyers and sellers. Narrow markets are characterized by low liquidity and high volatility.
#7 – Market Risk/Systematic Risk
Market risk is the probability of losses due to market reasons like slowdown and changes in rates. Market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk. affects the entire market together. In a bond market, no matter how good an investment is, it is bound to lose value when the market declines. Interest rate risk is another form of market risk.
#8 – Default Risk
Default risk is defined as the bond issuing company’s inability to make required payments. Default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors. is seen as other variants of credit risk where the borrowing company fails to meet the agreed terms of the issue.
#9 – Rating Risk
Bond investments can also sometimes suffer from rating riskRating RiskRisk rating assesses the risks involved in the daily activities and classifies them (low, medium, high risk) based on the impact on the business. It helps to look for control measures that would help cure or mitigate the effects of the risk and negate the risk altogether. where a slew of factors specific to the bond, as well as the market environment, affect the bond rating, thus decreasing the value and demand of the bond.
Different types of bond risks elucidated above almost always decrease the worth of the bond holding. The decline in the value of bonds decreases demand, thus leading to a loss of financing options for the issuing company. The nature of risks is such that it doesn’t always affect both the parties together. It favors one side while posing risks for the other.
Advantages of Understanding Bond Risks
Although the term advantages of risks is an oxymoron, it is very important to understand that it is the risks only that warn investors beforehand so that they can diversify their portfolios and be aware of what is coming. This not only prevents severe market unrest but also creates an efficient market.
- Proper assessment of every bond issue for the above risks is very important in order to minimize the impact.
- A new market entrant can be easily duped by an issue that looks good on the face but is marred by so many risks that the eventual payout might not be attractive at all.
- Good market knowledge is essential for bond investments; else otherwise, safe investment heaven might turn out to be a loss-making exercise only.
- Avoiding too much dependency on a particular type of bond can help mitigate these risks to some extent.
- Some debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans. come equipped with clauses that aim to minimize a specific type of risk. For e.g., Treasury Inflation-Protected Securities or TIPS have their returns tied up to the consumer price indexConsumer Price IndexThe Consumer Price Index (CPI) is a measure of the average price of a basket of regularly used consumer commodities compared to a base year. The CPI for the base year is 100, and this is the benchmark point.. In the event of rising inflation (Inflation risk), returns also get adjusted accordingly, preventing the investor from losing purchasing power.
- It is also very important to assess one’s risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation. before jumping into investments.
Generally speaking, higher risks generate higher returns. However, all investments don’t always perform as per expectations even after applying risk mitigation techniques mostly since it is very difficult to quantify risks, and hence, complete elimination becomes impossible.
This has been a guide to What are Bond Risks and its Definition. Here we discuss the top 9 types of Bond Risks along with its advantages and disadvantages. You can learn more about accounting from the following articles –