6 major bond risks

Bonds can be an excellent tool for generating income and are widely regarded as a safe investment, especially when compared to stocks. However, investors should be aware of the potential pitfalls of holding corporate bonds and government bonds. Below, we will discuss the risks that may affect your hard-earned returns.

Key points

  • Risk #1: When interest rates fall, bond prices rise.
  • Risk #2: The income must be reinvested at an interest rate lower than the previous income of the fund.
  • Risk #3: When inflation rises sharply, bond yields may be negative.
  • Risk #4: Corporate bonds depend on the issuer’s ability to repay debts, so there is always the possibility of default in repayment.
  • Risk #5: A low corporate credit rating may lead to an increase in loan interest rates, thereby affecting bondholders.
  • Risk #6: Low bond buying interest will cause price fluctuations.

1. Interest rate risk and bond prices

The first thing bond buyers should understand is the inverse relationship between interest rates and bond prices. As interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices tend to fall.

This happens because when interest rates fall, investors try to capture or lock in the highest interest rate for as long as possible. To this end, they will purchase existing bonds with interest rates higher than current market rates. This increase in demand has translated into an increase in bond prices.

On the other hand, if current interest rates rise, investors will naturally sell bonds with lower interest rates. This will force bond prices to fall.

Let’s look at an example. Investors own bonds that are traded at face value and have a yield of 4%. Suppose the current market interest rate rises to 5%. What will happen? Investors will want to sell 4% of bonds to support bonds with a 5% return, which in turn will drive the price of 4% of bonds below par.

2. Reinvestment risk and callable bonds

Another danger facing bond investors is the risk of reinvestment, that is, the risk of having to reinvest income at an interest rate lower than the previous income of the fund. One of the main manifestations of this risk is that interest rates fall over time and the issuer exercises callable bonds.

The redeemable feature allows the issuer to redeem the bond before maturity. As a result, bondholders receive a principal payment, which is usually a slight premium over the face value.

However, the downside of bond subscription is that investors will leave a pile of cash, and they may not be able to reinvest at a comparable interest rate. Over time, this reinvestment risk will adversely affect investment returns.

In order to compensate for this risk, investors receive higher bond yields than similar bonds that are not redeemable. Active bond investors can try to reduce the reinvestment risk in their portfolio by staggering the potential redemption dates of different bonds. This limits the opportunity to call many bonds at once.

3. Inflation risk and bond duration

When investors buy bonds, they basically promise to obtain a fixed or variable rate of return for the duration of the bond or at least during the holding period.

But what happens if the cost of living and inflation rise sharply, and the growth rate is faster than income investment? When this happens, investors will see their purchasing power drop, and when inflation is factored in, they may actually get a negative rate of return.

In other words, assume that the investor’s bond yield is 3%. If the inflation rate increases by 4% after the purchase of bonds, the investor’s true rate of return is -1% due to the decline in purchasing power.

4. Bond credit/default risk

When investors buy bonds, they are actually buying debt certificates. In short, this is the borrowed funds that the company must repay with interest over time. Many investors do not realize that corporate bonds do not have the full trust and credit guarantee of the US government, but depend on the issuer’s ability to repay the debt.

Investors must consider the possibility of default and incorporate this risk into their investment decisions. As a means of analyzing the possibility of default, some analysts and investors will determine the company’s coverage before investing. They will analyze the company’s income and cash flow statement, determine its operating income and cash flow, and then weigh it against debt service expenses. The theory holds that the greater the coverage (or operating income and cash flow) that is proportional to debt service costs, the safer the investment.

V. Downgrade of bond ratings

Major rating agencies such as Standard & Poor’s Rating Services or Moody’s Investor Services often evaluate a company’s ability to operate and repay debt problems. Ratings range from AAA for high credit quality investments to D for default bonds. The decisions and judgments adopted by these institutions have a great impact on investors.

If the issuer’s corporate credit rating is low or its ability to operate and repay is questioned, banks and lending institutions will notice and may charge higher interest rates for future loans. This may adversely affect the company’s ability to repay debt and hurt existing bondholders who may have been seeking to sell positions.

6. Liquidity risk of bonds

Although there is almost always a ready market for government bonds, corporate bonds are sometimes a completely different animal. Due to the thin market and few bond buyers and sellers, investors may not be able to sell their corporate bonds quickly.

Low buying interest in specific bond issuances can lead to large price fluctuations and adversely affect bondholders’ total sales returns. Just like stocks traded in a light market, when selling a bond position, you may be forced to accept prices that are much lower than expected.

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