All investments carry risks. Bonds are no exception. Those risks include default/credit risk, a ris...
All investments carry risks. Bonds are no exception.
- Default/ Credit risk: There is a risk that the issuer may fail to pay you the interest or principal as scheduled.
- Interest rate risk: When the interest rate rises, the price of a fixed rate bond will normally drop, and vice versa. If you want to sell your bond before it matures, you may get less than your purchase price. Moreover, longer-term bonds are more sensitive to interest rate changes than shorter-term bonds. For instance, a 30-year zero coupon bond is usually more sensitive to interest rate changes than a 10-year fixed rate bond. This is because a zero coupon bond does not make any interest payments during its term and repayment only occurs upon its maturity. The value of the zero coupon bond is calculated by discounting its repayment amount at maturity back to its present value. It follows that the shorter a bond's term, the lesser the impact of such a discount on its value, and the lesser the impact that interest rate changes will have on its value.
- Exchange rate risk: If your bond is denominated in a foreign currency, you face an exchange rate risk. Any fall in the foreign currency will reduce the amount you receive when you convert a payment of interest or principal back into your local currency.
- Liquidity risk: You may need to sell the bonds before maturity when you have an urgent cash-flow need or use the capital for other investments. However, you may not be able to sell your bond if the liquidity of the secondary bond market is low.
- Inflation risk: The return on bond investments will lose purchasing power if commodity prices go up. Inflation is therefore a serious concern for those who need to rely on the regular income from bonds.
- Event risk: A corporate event such as a merger or takeover may lower the credit rating of the bond issuer. In case the corporate restructurings are financed by the issuance of a large amount of new debt-burden, the company's ability to pay off existing bonds will be weakened.
High yield bonds carry additional risks:
- Higher credit risk:High yield bonds are often rated below investment grade or unrated. While ratings from the credit rating agencies do not guarantee the creditworthiness of the issuers, investing in non-investment grade or unrated bonds may incur higher risk of default by the issuers.
- Vulnerability to economic cycles: High yield bonds are more vulnerable to economic changes. During economic downturns, the value of these bonds typically fall more than that of investment-graded bonds because investors become more risk averse and default risk rises.
Below are the additional risks associated with bonds having special features:
- Priority of claims: Subordinated bondholders have lower priority of claims than other bondholders in case of liquidation of the issuer. You could only get back the principal after other senior creditors are paid.
- Maturity: Perpetual bonds do not have a fixed maturity date. The interest pay-out of these bonds depends on the viability of the issuer in the very long term.
Some bonds may have extendable maturity dates. Hence, you do not have a definite schedule of principal repayment, which may adversely affect your liquidity.
- Contingent write down or loss absorption feature: Bonds with these features may be written-off fully or partially, or converted to common stock on the occurrence of a trigger event. You should understand these additional features and the implications of the trigger event specified under the bonds' terms and conditions.
- Interest payment terms: Some bonds have variable interest payment terms such as from fixed rate to floating rate. Some bonds also allow the issuer to defer payment of interests in whole or in part for a period of time under certain conditions. You would face uncertainty over the amount and time of the interest payments to be received.
- Callable, convertible or exchange in nature: Some bonds are callable in nature and contain an option which grants the issuer the right to redeem the bond before it matures. If you hold a callable bond, when the interest rate goes down, the issuer may redeem the bond before maturity. If this happens and you have to re-invest the proceeds, the yields on other bonds in the market will generally be less favourable.
If your bond is "convertible" or "exchangeable", you also face equity risk associated with the stock. A fall in the stock price will usually cause the bond price to fall.