Bonds 103: Considering the Risks of Bond Investing
What you will learn
- Key risks associated with the bond market
- Potential risks in an investment portfolio
What is interest rate risk?
Owing to the strong relationship between bonds and interest rates, one of the main risks facing bond investors is interest rate risk. Essentially this is the risk that the price of a bond will fall when interest rates rise.
The price of a bond reflects the value of the income it delivers through its coupon payments. When prevailing interest rates increase, the value of a particular bond coupon decreases because it is now less attractive when compared to the coupons of newer bonds being offered with higher yields. Thus, the price of the older bonds drops.
What is inflation risk?
Inflation can be a problem for investors because it chips away at the future purchasing power of their savings and investment returns.
For example, an investment that returns 2% before inflation in an environment of 3% inflation will produce a negative real return of -1%.
Inflation can be particularly problematic for bond investments where the regular interest payments remain fixed until maturity. Over time, the purchasing power of these payments declines in response to inflation.
The interest rates on bonds typically are expressed as either:
- A nominal rate, which is not adjusted for inflation; or
- A real interest rate, which is the nominal rate minus the rate of inflation. For example, if a bond has a nominal interest rate of 5% and inflation is 2%, the real interest rate will be 3%.
Apart from purchasing power, inflation can affect bonds in another way. When inflation rises above a certain level, interest rates also tend to rise as central banks adjust their policy rates in an effort to discourage consumer spending. In response, bond prices fall.
What is default risk or credit risk?
Every bond carries some risk the issuer will default – or, in other words, fail to pay the investor coupon and principal payments on time and in full.
Independent credit rating services assess the default risk of bond issuers and publish credit ratings that help investors evaluate risk. These ratings help determine the interest rates on individual bonds.
An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Purchasing a bond with a lower credit rating may deliver higher returns, but the investor must bear the additional risk that the issuer will default.
Generally speaking, government bonds in developed market economies are considered low risk investments as the risk of default is typically highly unlikely. In some cases, bonds carry a government guarantee. Government bonds in emerging markets require a higher level of scrutiny as they may involve elevated risk levels.
The Commonwealth of Puerto Rico offers an example of the importance of careful research, even with government bonds. In 2016, the government of this unincorporated U.S. territory defaulted on debt that was supposedly guaranteed by its constitution, marking the first time since 1933 that a U.S. state or state-like entity failed to meet its debt obligations.
Corporate bonds fall into two broad categories – investment grade and speculative grade (also known as high yield or junk bonds).
Speculative grade bonds are issued by companies perceived to have lower credit quality and higher risk of default than more highly rated, investment grade companies. Ratings can be downgraded if the credit quality of the issuer deteriorates. Conversely, they can be upgraded if fundamentals improve.
What is reinvestment risk?
When investors receive coupon payments from their bond holdings, or when they are repaid their investment principal, they may choose to reinvest it into new bonds. If interest rates have dropped since they last bought bonds, they will be buying bonds offering lower rates of return. This is called reinvestment risk.
Reinvestment risk also can be triggered by the call features of a bond. Some bonds allow the bond issuer to “call” – or redeem – the bond prior to maturity. Typically, this happens during a falling interest rate environment, which leaves bond holders in a position where the new bonds available to them offer lower rates of return.
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