There are several types of risk that face bond investors. We will examine each of these risks to familiarize you with some if the basic pitfalls a bond investor can run into.
Interest Rate Risk - First and foremost, bonds are subject to swings in interest rates. Specifically, upward moves in interest rates erode the value of fixed payments to be received in the future (through discounting at a higher rate), thereby reducing the value of a straight bond. Interest rate risk has two components however that serve to offset each other to a degree. When interest rates rise, a bond first displays its price risk, or the risk that the bond will decrease in value. On the other hand, the coupons that a bond investor receives can now be invested at a higher rate than originally assumed in the yield-to-maturity formula. When interest rates fall, this risk is known as reinvestment risk, or the necessity of reinvesting coupons in lower yield securities. As you can see, as interest rates rise, price risk reduces the value of the bond, but the reinvestment rate increases. Depending on the type of bond, the movement in interest rates, and the investment horizon for the bond investor, these risk characteristics can behave quite differently and rarely serve to perfectly offset each other. If this was the case, bond prices would hardly ever move.
To understand a bond's price risk better, please see our article entitled Price Risk: Duration and Convexity
Credit Risk - Credit risk or default risk is the possibility that a corporate bond in your portfolio will no longer make any payments. Corporate or government bankruptcies can result in a worthless bond, even though bondholders are higher in the repayment hierarchy than stockholders. Such credit risk can be addressed through ratio analysis focusing on a company's debt burdens and cash flow capabilities. Default rates in the U.S. have been relatively low. A Moody's study suggests that the annual default rate for high-yield issues between 1970 and 1992 was 4.58%. Other studies showed that the annual default rate of all bonds was near 0.5%. On the whole, the historically higher returns of holding a well-diversified portfolio of high-yield bonds have exceeded the additional default risks involved.
Credit rating agencies can help investors determine the creditworthiness of corporate bonds. Standard & Poors and Moody's are probably two of the most familiar rating agencies. S&P ratings range from AAA the highest rating indicating an excellent ability to repay obligations to D debt that is currently defaulted. Ratings below BBB are considered "junk" or high-yield issues. The Standard & Poors ratings from highest to lowest are listed below.
AAA - Excellent capacity to repay principal and interest
AA - Very strong capacity to repay principal and interest
A - Strong capacity to repay principal and interest.
BBB - Adequate capacity to repay principal and interest.
BB - Little near-term weakness, but faces major ongoing uncertainties or exposure to adverse business conditions.
B - Has the ability to repay interest. Poor economic conditions would likely impair ability to repay principal and interest
CCC - Currently susceptible to default. Dependent on favorable economic and business decisions
CC - debt that is subordinated to senior debt that has been assigned a CCC+ rating
C - debt that is subordinated to senior debt that has been assigned a CCC rating
D - Debt currently in default
Corporate bonds often react to changes in economic conditions. During times of economic uncertainty, the "spread" between corporate and government bond issues widens. This means that corporate bonds are pricing in additional risk, thereby reducing the value of an existing bond. If a corporation undergoes a positive credit event, such as merging with a stronger company, this risk spread is narrowed, resulting in a higher value bond.
Prepayment Risk - Bonds with embedded callable options also contain an element of prepayment risk. When interest rates decline, corporations are more interested in retiring their debt and reissuing bonds at a lower interest rate. This hurts investors because the bond upward price mobility is limited by the call price, which is generally a few points over par. This premium usually does not completely compensate for the lost price appreciation of the bond. For allowing the corporation the option to call the bond issue, callable bond investors usually receive higher yields.
A prepayment presents another risk to investors related to reinvestment risk that we discussed earlier. Bonds are usually called when interest rates have fallen. Therefore, investors whose bonds are called face a lower interest rate environment in which to reinvest their money.
Political Risk - Investments in foreign denominated bonds of a foreign country offer a host of additional risks including currency risk, and economic risk. Political instability can lead to a reduction in the value of bonds backed by unstable governments. Further, currency fluctuations and regional economic conditions can adversely affect the value of foreign bonds.
This is a brief discussion of some of the major risks associated with bond investing. The bond market and its myriad of fixed-income securities can be incredibly complex. Most individual investors prefer to utilize bond funds for their fixed-income needs.
