Last week, we looked at investing in bonds as an investment instrument and touched a bit on the risks associated with such investments. This article takes a closer look at the risks of investing in Bonds.
In its simplest sense, risk is usually defined as the variability of the returns from an investment i.e. the returns may be higher or lower than expected. Investments with greater inherent risk must promise higher expected returns if investors are to be attracted to buying them. In this article, we will look at some of the risks that bond investors are exposed to.
When you buy bonds, the returns you obtain from the bond, from the day you purchase it to the day you sell it, can be divided into two main parts. First, the market value of the bond if you sell it and second, the income you receive from the coupon payments while you hold the bond plus any additional income from reinvesting these coupons payments. Several factors affect one or both of these parts. The risks of investing in bonds are therefore the impact that these factors have on the returns from the bond. What are these risks?
The principal risk facing bond investors is that of market or interest rate risk. Interest rates and bond prices move in opposite directions. For an investor who plans to hold the bond to maturity (i.e. the date on which the principal will be repaid), the change in price before maturity is of no concern. However, for an investor who wishes to sell the bond before maturity, changes in market interest rates will affect the value of their bonds. An increase in market interest rates will result in a capital loss on the bonds and vice versa.
Another type of risk is re-investment risk. It is generally assumed that the income earned from the bond is re-invested. The additional income that is obtained from re-investing the coupons received will usually depend on the prevailing interest rate levels at the time and the investment strategy employed by the investor to re-invest. Re-investment risk is the risk that interest rates at which the coupons can be re-invested will fall. Re-investment risk is greater for bonds with longer terms to maturity and higher coupons. It is important to note that interest rate risk and the re-investment risk oppose each other.
Some bonds are subject to call risk. Some bonds have “call” features which allows the issuer to redeem or to “call” all or part of the bond before the maturity date. For investors the risk is that, firstly, the pattern of cash flows of the callable bond is not known with certainty. Secondly, because the issuer will call the bond when interest rates are down, the investor is exposed to re-investment risk i.e. that the proceeds of the bond will have to be re-invested at lower interest rates. Thirdly, capital gains may be reduced if the bond is called earlier as the price of the bond may not have risen much above the price at which it was bought.
Bond investors are also subject to credit risk or default risk. This refers to the risk that the issuer of the bond may default on the payments i.e. be unable to make the principal or coupon payments. Credit ratings are often used to rate the risk of default of an issuer.
Inflation risk arises because of the variation in the value of the coupons you receive from the bond due to inflation, as measured in terms of purchasing power. For example, if you buy a 5-year bond with a coupon rate of 7%, but the rate of inflation increases from 3% to 5%, the purchasing power from the income of the bond falls.
Marketability and Liquidity Risk is the ability to sell the bond in the secondary market at or close to its real market value in a desired time frame. This is measured by the difference (i.e. spread) between the bid and the offer price. The greater the difference between the bid and offer prices of the bond, the greater its liquidity risk as matching bid and offer may take longer to eventuate. Bonds that are attractive to investors will generally have lower liquidity risk and trade at a narrower spread.
Political or Legal Risk. The value of bonds may be affected by actions taken by a government or regulatory authorities. For example, tax-exempt bonds may be declared taxable before the bond matures. This will have a negative impact on the price of the bond and its marketability in the secondary market.
All investments are subject to risks of varying kinds and bonds are no different. The returns that you can make on your investments will compensate you for the risks that you bear in making the investment. Hence, it is important to understand the nature of the risks that may affect your investment and its expected returns. If you make your investment decisions carefully, in line with your investment objectives, you have a good chance of making reasonable returns.
Reserve Bank of Fiji