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Understanding the Risks when it comes to Bonds
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Understanding the Risks when it comes to Bonds

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Risks with Bonds

  • What are the risks when investing in a bond?
  • As noted previously, bonds are generally considered to be considerably less risky than stocks. Much of this is due to the stable and certain nature of the payments we receive.
  • Coupons and the par value of a bond for instance are a contractual obligation between the investor and the company. Failure to pay coupons can result in the company being placed into liquidation or bankruptcy. As a result, if a company is able, they will pay these reducing the risk of our returns.
  • This contrasts with dividends which cannot be legally compelled. Meaning a high dividend paying company could simply cease paying dividends entirely if the board felt it was the best option.
  • We see two types of risk, in general, when we invest in bonds.
    • Interest rate risk. This is the risk associated with a change in prevailing interest rates. It has two primary effects on an investor.
    • It changes the price of the bond resulting in price risk. Recall that as the yield increases the price decreases meaning that if we were to sell the bond early, we would incur a capital loss.
  • It changes the rate of return for our coupons. We assume that people will reinvest the coupons they receive from their bond back into the market at the prevailing interest rate. If yields increase, then the return I earn on my reinvested coupons is higher than it would have been.
  • It is worth noting that price and reinvestment factors are offsetting.
  • When yields increase, price decreases. But reinvestment income increases offsetting some, but usually only a portion, of the price decrease.
  • Additionally, both price and reinvestment risk are greater for longer bonds then shorter.
  • When we hold a bond until maturity, we can effectively ignore interest rate risk as we will receive the yield to maturity of the bond at the time that we purchased the bond.
  • Credit Risk or Default Risk. This affects all bonds and is the risk that the company cannot meet its legal obligations.
  • This is the risk we need to be more concerned with, especially if we are planning on holding a bond to maturity. The risk here is that we forgo any remaining coupons and the par value due to be repaid at the end of the bond.
  • How badly we will be affected depends on several factors, including the value of the assets of the company and where in the liquidation pay-out order the bond sits.
  • For instance, bonds and debt can have different seniorities meaning a bond could rank lower than other more senior debt holders, increasing the risk of receiving little in the case of bankruptcy.
  • To help investors understand the credit risk they are taking with a bond, issuing companies often pay rating agencies to rate the creditworthiness of the bond.
  • Globally there are three recognised credit rating agencies: Standard and Poors, Moody’s and Fitch. They all use slightly different rating systems and the weighting they give to the underlying factors is different, but they seek to do the same thing, quantify the probability that a bond will default.
  • Below is a diagram that explains the systems and attempts to explain what each rating means.

CREDIT WORTHINESS

  • In terms of the relationship between risk and return, the higher the rating of the bond the lower the yield to maturity that a bond will pay. Ratings can be revised overtime.
  • As changes occur, the required yield for the bond will also adjust. Although adjustments tend not to occur that often.
  • This link offers more information on the rating system by Standard and Poors, the most widely recognised rating agency.
  • It is worth noting that credit ratings also apply to government bonds as well as corporate bonds.
  • While bankruptcy works differently for countries, it is still possible for countries to default on bonds. For instance, in 2020 Argentina, Ecuador, Lebanon, Surinam and Zambia all defaulted on government bonds.
  • The consequences for countries defaulting are different, after all a country cannot be liquidated and sold! Countries that default on bonds typically wind up unable to access international debt or, if they can, they have to pay significantly higher interest rates to compensate for the risk involved.
  • This places considerable pressure on the economy and can lead to austerity type policies as we saw in the European debt crisis in 2010.
  • In addition, foreign exchange gets more expensive and stock markets tend to crash. Countries try to avoid bankruptcy just like companies do.

OVER TO YOU

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How to Invest: Modern-Day Financial Decisions

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