Investment Risks of Bonds

Over the long term, investment returns of bonds are lower than for stocks, but people invest in bonds because they are considered safer investments.

But bonds have risks. Generally, risk is the possibility of something undesirable. Since the goal of investing is to get the greatest return possible for the investment, investment risk is the possibility that the investor will get back less than the expected return, or less than an alternative investment — what economists call opportunity costs. The risks associated with bonds, however, are usually small compared to stocks, options, and other derivatives, so many people invest in them.

Many risks in bonds apply to other investments as well. Inflation risk, for instance, affects every investment. Not all risks apply to every bond. In fact, many risks have an inverse relationship — when one goes up, the other goes down.

The most important risk for bonds is market risk or interest rate risk, because interest rates change continually, and this risk affects virtually every security, but especially bonds.

Interest Rate Risk (Market Risk)

The price of bonds usually changes oppositely of interest rates, with some exceptions, such as securities with put options and interest-only mortgage-backed securities. It is called market risk, because it is a risk only if one wishes to sell before maturity in the secondary market.

Duration measures interest rate risk, about equal to the % change in the market price of a bond to a 1% change in market interest rates. The longer the duration, the greater the interest rate sensitivity. When interest rates are lowest, then interest rate risk is greatest. Rising interest rates will cause bond prices to fall. However, when interest rates are high, then bonds with longer durations have a greater potential for capital gains when interest rates decline, because bond prices will rise when interest rates fall unless other factors depress bond prices.

Related to market risk is liquidity risk, the spread between the bid/ask prices for a security being offered in the secondary market. Securities with low trading volumes will have wide bid-ask spreads, meaning the price that the security can be sold may be significantly less than another similar recent transaction even without change in any other significant factor. For individual investors, this risk exists only if the investor wants to sell the security before maturity. Institutional investors, such as mutual funds, who need to mark their securities to the market, for reports, or to determine the NAV, for instance, must calculate a lower effective price for those securities with little liquidity.

Reinvestment Risk

Reinvestment risk arises from declining interest rates. When bonds mature, reinvested money usually earns a lower interest rate for the same amount of risk. Furthermore, reinvested cash flows from a bond will usually earn a lower rate of return than the original investment.

This risk is contrary to interest rate risk, because when interest rates rise, market risk increases, but reinvestment risk declines. Thus, reinvestment risk helps neutralize market risk — strategies based on these opposing risks is called immunization.

Call Risk (Timing Risk)

Some bonds are callable — the issuer may redeem the bond before maturity. How, when, and at what price it may do so is specified in the indenture of the bond.

A callable bond has both a market risk and a reinvestment risk. The market risk arises, because even though a bond normally increases in value as interest rates drop, a callable bond will not rise above its call price because the issuer will redeem the bond at its call price before maturity. The reinvestment risk exists because a bond is more likely to be called when interest rates decline, so the investor must settle for a lower rate of return for reinvested money.

Prepayment and Extension Risk

Equivalent to call risk in mortgage-backed securities is prepayment risk, the risk that homeowners will prepay their mortgage when interest rates decline, or when they sell their home. Prepayment risk increases as interest rates decline.

Note that if interest rates are rising, then it benefits investors of mortgage-backed securities to receive prepayments so that the money can be reinvested for a higher rate of return. However, prepayments will decline when interest rates rise, and this risk is called extension risk, because fewer prepayments yield less money to be reinvested at higher rates. Extension risk increases as interest rates rise. Note, that, although both prepayment risk and extension risk involve prepayments, they are opposite risks. When one risk declines, the other rises, and vice versa. So, for instance, if interest rates are falling, then extension risk declines but prepayment risk rises.

Credit Risk

The price of a bond depends on the issuer's credit rating, its ability to pay its debt obligations. The greater the credit rating of the issuer, the less yield the issuer must pay on the bond to sell it. In the secondary market, the bond's price is proportional to the issuer's credit rating for a given yield.

The top major services, recognized as nationally recognized statistical rating organizations (NRSRO) by the Securities and Exchange Commission, that rate bonds are:

• S&P Global Ratings
• Moody's Investors Service, Inc.
• Fitch Ratings, Inc.
• A.M. Best Rating Services, Inc.
• Check the full current listing: SEC.gov | Current NRSROs

Standard & Poor's ratings range from AAA for the highest credit rating to D, for bonds in default. Moody's rating system uses a slightly different letter grade that ranges from Aaa to C. Other rating agencies have similar ratings. The top grades — rated at least BBB by Standard & Poor or Baa by Moody — are considered investment grade; bonds with lower ratings are considered speculative grade, which pays higher interest rates for the higher risk of loss; thus, these bonds are sometimes called high-yield bonds. Bonds at high risk of default, with C or lower ratings, are called junk bonds. Consequently, junk bonds pay the highest interest rates. Financial institutions, trustees, and other fiduciaries are generally restricted to purchasing investment grade bonds to limit credit risk.

3 types of credit risk:

1. Credit default risk is the risk that the issuer will default on its payments, which jeopardizes both interest and principal.
2. Credit spread risk results because the market perceives that the issuer is weaker financially and may have trouble maintaining payments, resulting in a larger spread between bid/ask prices in the secondary market.
3. Downgrade risk is the risk that the current credit rating will be downgraded by 1 or more of the credit rating agencies.

Credit rating agencies also announce reviews of particular issuers at times when the financial health of the issuer is changing, which may be an upgrade or downgrade. The duration of this review is called a rating watch or a credit watch. Credit rating agencies may also announce a rating outlook for an issuer, which is an opinion by the credit rating agencies as to the creditworthiness of the issuer within the next 6 months to 2 years. A positive outlook indicates that the issuer's rating will be raised, whereas a negative outlook indicates a downgrade; a neutral rating indicates no likely change in status.

Obviously, a negative credit watch or a negative rating outlook will decrease the price of all bonds by that issuer in the secondary market, and will force the issuer to offer higher yields for any new issues to compensate investors for the higher perceived risk.

Not all bonds have a credit rating. Sometimes the issuer will not pay for a credit rating, and some securities, such as U.S. Treasuries don't need it, because they are considered free of default risk.

Note, also, that credit risk is proportional to the term of the security, especially for long-term bonds, because the longer the term, the greater the chance that issuer's credit rating will be downgraded.

Event risks are major events that can downgrade the credit rating of the issuer significantly — a nuclear accident at a nuclear power plant, for instance, or the leveraged buyout of a company, where the company's debt is increased significantly to finance the buyout, thereby lowering the credit rating of the company, usually below investment grade status.

Change of Control Covenants May Reduce Risks for Bondholders of Leveraged Buyouts

Private equity firms and management companies have been buying companies through leveraged buyouts (LBOs), which uses the acquired company's cash flow to pay debt used to acquire the company. This can cause the credit rating of the company to drop to junk status and the prices of its bonds to drop. Consequently, many companies add a change of control covenant to the bond indentures that either limits the amount of additional debt that the company can take on, or the company must buy back the bonds, sometimes at a slight premium, when a change of control occurs. Some companies add a put option to its bonds so that bondholders can sell the bond back to the company at par value before maturity. For instance, Expedia recently sold 12-year bonds with a put option that allowed bondholders to turn in the bond after 7 years for par value.

Inflation Risk

Inflation risk is the risk that the value of money will decline, which it does continually most of the time. If the interest rate of the bond is not high enough to compensate for inflation, then real returns may be negative. On the other hand, it is possible to profit from deflation that sometimes occurs when interest rates rise. A good example is when interest rates are rising, newly issued bonds pay more, while prices of assets that usually require borrowing, such as real estate, start declining. Thus, for instance, you could buy 4-week T-bills to save for a house or for a down payment. As the T-bills expire, they can be re-invested at progressively higher rates, while rates are rising. Meanwhile, real estate prices may fall because it becomes more expensive to borrow money to pay for it. So the money earned on T-bills becomes even more valuable than the interest rate itself suggests when used to purchase real estate.

Legal Risk

Legal risk is the risk that changes in the law may adversely affect bond prices. Most legal risk is associated with the tax exemption of particular bonds, especially municipal bonds. Because municipal bonds are exempt from federal taxation, and, may also be exempt from state and local taxes, municipalities can pay a lower interest rate. The higher the marginal tax rate of taxpayers, the lower the interest rate that the municipality must pay to sell its bonds. However, if the top marginal tax rates decline, then the advantage of the tax exemption also declines, and with it, the price of the bond in the secondary market. This is called tax risk.

The 2^nd type of legal risk occurs because tax-exempt bonds have to satisfy specific legal requirements, and if it is later determined that the bond does not satisfy these requirements, its tax-exempt status may be eliminated, reducing not only the effective return of the bond after taxes, but it would reduce the bond price in the secondary market because its now taxable yield must equal the taxable yield of other, comparable bonds.

Risks Specific to International Bonds

Foreign Exchange Risk

Foreign exchange risk is the possibility that the foreign currency in which a bond is denominated will depreciate against the domestic currency. Currency exchange rates are changing all the time, so if the bond currency depreciates against the investor's domestic currency during the bond term, then the investor will either increase losses or reduce profit. Of course, if the foreign currency appreciates, then this will yield greater profits.

Bond prices in the foreign country may also decline if interest rates rise in that country for the same reason that rising interest rates decrease the price of bonds in this country.

Volatility Risk

Bonds issued from emerging countries are more volatile than most other bonds since these countries are viewed as being less stable and less predictable. Thus, there is a greater price reaction to news about the issuer or about economic conditions in the issuer's country.

Sovereign risk (country risk, political risk)

Sovereign risk (aka country risk, political risk) is the risk associated with the laws of the country, or to events that may occur there. Particular events that can hurt bonds are the restriction of the flow of capital, higher taxes, and the nationalization of the issuer. Also, as recently evinced by the Dubai crisis, when the issuer defaults, the legal remedies for bondholders may be weak or uncertain.

Convertibility Risk

A particular form of sovereign risk is convertibility risk, when exchanging foreign currency for domestic currency is prohibited. The only hope for an investor in this situation is to accept local currency or wait until the rules change.

Disclosure Risk

Because many countries, especially emerging countries, have very lax or inadequate laws regarding financial disclosures or accounting rules, it can be difficult to assess the true creditworthiness of the bond issuer. Disclosure risk results from this lack of disclosure about an issuer or accounting rules that don't adequately reflect the true financial status of the issuer.

Conclusion

Bonds have other risks. Yield-curve, or maturity, risk, for instance, is important in hedging positions where the portfolio of bonds is hedged with bonds of different maturities, and the interest rates of these bonds is assumed to change by a certain amount for a given change in market rates. Yield-curve risk results when bonds prices of different maturities deviate from this assumption when market rates change.

Sector risk results when an entire sector of securities declines in prices or yields, because of common causes affecting the sector. Any risk affecting the yield of bonds is also called basis risk.