Investment Risks of Fixed Income Securities
Most fixed income securities have a par value that pays a specific rate of interest on that value, or otherwise has a knowable rate of return; hence the term fixed income security.
In the most general sense, 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 his investment or his expected return, or that he will get less than he could have had if he had invested his money elsewhere—what economists call opportunity costs. These risks associated with fixed income securities, however, are usually small compared to stocks, options, and other derivatives, which is why many people invest in them. It is not possible to lose more than your investment in fixed income securities, as you can buying stocks on margin, for instance, because it makes no sense to borrow money to pay for fixed income securities, since the interest rate that you would be paying would almost certainly be more than you could earn. And it is not likely that you will lose your initial investment because bondholders have priority over owners if the company goes bankrupt and usually receive periodic payments of interest, and many issuers of bonds are governments or their agencies, which have taxing power. And because the United States government not only has taxing power, but can print money, investments such as U.S. Treasuries, are virtually risk-free, at least in regards to principal and interest payments.
Many of the risks in fixed income securities apply to other investments as well. Inflation risk, for instance, affects every investment. Not all risks apply to every fixed income security. In fact, many risks have an inverse relationship—when one goes up, the other goes down, which is best represented pictographically by a seesaw.
Generally, the most important risk for fixed income securities is market risk or interest rate risk, because interest rates change continually, and this risk affects virtually every security.
Market Risk (Interest Rate Risk)
The price of fixed income securities 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.
Illustrative Example—the Reciprocal Relationship between Bond Prices and Interest Rates
You buy a bond when it is issued for $1,000 that pays 8% interest. Suppose you want to sell the bond, but since you bought it, prevailing interest rates have risen to 10%. You will have to sell your bond for less than what you paid, because why is somebody going to pay you $1,000 for a bond that pays 8% when they can buy a similar bond of equal credit rating and get 10%. So, to sell your bond, you would have to sell it so that the $80 that is received per year in interest will be 10% of the selling price—in this case, $800, $200 less than what you paid for it. (Actually, the price probably wouldn't go this low, because the yield-to-maturity is greater in such a case, since if the bondholder keeps the bond until maturity, he will receive a price appreciation which is the difference between $1,000, the bond's par value and what he paid for it.) In such a case, the bond is said to be selling at a discount. If the interest rate of a new bond issue is lower than what you are getting, then you will be able to sell your bond at a higher price than what you paid—you will be selling your bond at a premium.
Duration is a measure of this risk, which is approximately equivalent to the percentage change in the market price of a bond to a 100 basis point change in prevailing interest rates.
Related to market risk is liquidity risk, which is the spread between the bid and ask prices for a security being offered in the secondary market. If there is not much interest in the security, then the bid-ask spread may be wide, which means that the price that the security can be sold may be significantly less than another similar recent transaction even when there is no 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, will have to calculate a lower effective price for those securities that have little liquidity.
Reinvestment risk is based on the assumption that cash flows from a fixed-income security are reinvested, so that interest can be earned on interest, and, thus, the risk is that the reinvested money will not earn the same rate of return as 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 to 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 probably 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 are declining, and, thus, the investor will have to settle for a lower rate of return for money that is reinvested.
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 is also called contraction risk. 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 slow down when interest rates rise, and this risk is called extension risk, because less prepayments yields less money to be reinvested at higher rates. Thus, contraction risk and prepayment risk are equivalent and increase as interest rates decline. Extension risk increases as interest rates rise. Note, that, although both contraction risk and extension risk involve prepayments, they are opposite risks. Where one exists, the other does not. So, for instance, if interest rates are falling, then there is no extension risk, but there is contraction risk, or prepayment risk, and vice versa.
The price of a bond depends on the issuer's credit rating, or perceived ability to pay its debt obligations. The greater the credit rating of the issuer, the less yield the issuer has to 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 5 major services, recognized as nationally recognized statistical rating organizations (NRSRO) by the Securities and Exchange Commission, that rate bonds are S&P, Moody's, Fitch, A.M. Best, and Dominion Bond Rating Service. 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 referred to as high-yield bonds. Bonds at high risk of default, with C or lower ratings, are referred to as 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.
There are 3 types of credit risk:
- Credit default risk is the risk that the issuer will default on its payments, which jeopardizes both interest and principal.
- Credit spread risk results because the market perceives that the issuer is in weaker financial health and may have trouble maintaining payments in the future, resulting in a larger spread between bid and ask prices in the secondary market.
- Downgrade risk is the risk that the current credit rating will be downgraded by one 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 in the near future, whereas a negative outlook indicates that there may be 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 fixed income securities 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 fixed income securities 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 basically risk-free.
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. As a consequence, many companies have added 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 is the risk that money obtained in the future will be worth less when it is obtained, which is almost always the case. The real risk is how much this risk will be. On the other hand, it is possible, in some cases, to take advantage of deflation that occurs when interest rates rise. A good example is when interest rates are rising, newly issued fixed-income securities start to pay more, while prices of things that generally require borrowing, such as real estate, start declining. Thus, for instance, one could buy 4 week T-bills as a way 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). In the meantime, real estate prices are falling because it is becoming more expensive to borrow the money to pay for it. So the money earned on the T-bills becomes even more valuable than the interest rate itself suggests when used to purchase real estate.
Legal risk is the risk that changes in the law may adversely affect the price of the bond. 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 tax rate of the exempt taxes, the lower the interest rate that the municipality has to pay to sell its bonds. However, if 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 known as tax risk.
The second type of legal risk occurs because tax-exempt securities have to satisfy specific legal requirements, and if it is later determined that the security does not satisfy these requirements, its tax-exempt status may be eliminated, which would reduce not only the effective return of the bond after taxes, but it would reduce the price of the bond in the secondary market because its now taxable yield would have to 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 will depreciate against the domestic currency. Currency exchange rates are changing all of the time, so if the bond currency depreciates against the investor's domestic currency during the term of the bond, then the investor will either lose money or not make as much profit. Of course, if the foreign currency appreciates, then this will result in 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.
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 a bond are the restriction of the flow of capital, taxation, and the nationalization of the issuer. Also, as recently evinced by the Dubai crisis, there may be uncertainty in the law in cases of default by the issuer or the law may provide weak remedies.
A particular form of sovereign risk is convertibility risk, which is the prohibition of the exchange of the foreign currency for domestic currency. The only hope for an investor in this situation is to accept local currency or wait until the rules change.
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.
There are other risks with fixed income securities, which are either specialized, or of a general nature. 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 prevailing rates. Yield-curve risk results when bonds prices of different maturities deviates from this assumption when prevailing 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 that affects the yield of fixed income securities is also referred to as basis risk.