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 risk 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 Risk
- Interest Rate Risk
- Call Risk
- Reinvestment Risk
- Credit Risk
- Liquidity Risk
- 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 investment 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 risk is specifically associated with the bonds that come with an embedded call option. When market rates decline, callable bond 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 rate 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 flow 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 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 risk is seen as other variants of credit risk where borrowing company fails to meet the agreed terms of the issue.
#9 – Rating Risk
Bond investments can also sometimes suffer from rating risk 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 instruments 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 index. 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 appetite 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 following articles –