October 13, 2012 in Bond
If you thought bonds were fail-safe and risk-free, please think again.
The fact is that bonds too, like most other investments, are subject to risks; however, the kind of risk, or its degree, may vary.
Bond Default Risk
Bond default risk is the risk one runs that the issuer of the bond may not be able to pay interest during the tenure of the bond, or repay the principal on its maturity.
This ability of the bond issuer to meet his commitments is based on his credit-worthiness, which in turn can be gauged by the issuer’s credit rating assigned by rating agencies such as S&P and Moody’s, as shown below. Borrowers with high ratings are more credit-worthy, and hence less likely to default on their bond commitments.
Therefore, one may decide to invest in bonds issued only by high-quality borrowers. But this added security has a price – one may have to settle for lower coupon rates. Conversely, a lower-rated borrower may have pay higher interest to attract investors to their bonds.
This is shown very well in the illustration below relating to yields on sovereign bonds.
Chart Courtesy FT,com
Clearly, in the above chart, Spanish and Italian government bonds are showing the highest yields because of their imminent default risk. Why?
Default risk > Low Bond Prices > Higher Yields
Interest Rate Risk
This is the risk inherent on a bond due to a change in the market interest rates. Suppose that interest rates move up after the issue of a bond. In that case, a person considering an investment in those bonds will seek to pay a lower price so that his effective interest earning will be in line with current market interest rates. This will cause the prices of those bonds to fall.
Therefore, when interest rates increase, prices of bonds fall. Conversely, when interest rates fall, bond prices appreciate, as shown in the following illustration:
Thus changing interest rates have an important impact on the value of a bond investment, and can be a source of great risk during times of hardening interest rates. Interest rate risk is more pronounced on bonds with longer tenures.
Purchasing power risk
The decline in the purchasing power of a currency, which is directly related to the inflation level in the economy, also affects bonds. As the interest and redemption amount on a bond are fixed, a decline in purchasing power means that the investor will effectively get a lower return on his investment.
Therefore, bonds fall in value during periods of rising inflation. During periods of low inflation, bond prices stay firm so long as the interest is higher than the rate of inflation.
This is the risk that an investor faces when he attempts to transact in a bond that is not actively traded. In such a case, the investor may have to pay a higher price to obtain the bond, or settle for a lower price when he’s out to sell.
Sometimes the borrower issuing the bonds becomes the subject of a corporate transaction such as a merger or acquisition. One result of the transaction may be that the credit worthiness of the bond issuer may be prejudiced, resulting in a fall in prices of that bond, and a loss to the investor.
This is the risk assumed by an investor that the bond issuer would redeem the bonds prior to their maturity, provided the bonds carry this option.
Normally issuers prefer up to call up the bonds in a situation of falling interest rates, and when the prevailing rate falls below the coupon rate on the bonds. Needless to say, the action benefits the borrower and deprives the investor of profits.