Many people consider purchasing bonds because they think it is a relatively safe way to grow money. This is true, assuming that you buy safe bonds. How do you tell the difference between safe bonds and risky ones?
The most important thing that differentiates bonds from each other are the types of risk that come with them.
You have to remember that bonds are simply loans that have a unique payback method. For an introduction to bonds, check out this article, which precedes this one in this series on bonds.
Since bonds are loans, we know that there is a chance that you may never see all or any of your money again (although this is unlikely).
This brings us to our first type of risk.
1. Credit Risk (Default Risk)
This risk potential is potentially the most devastating as it can lead to you losing all of your money.
The credit risk is the possibility that a borrower will not be able to pay all or any of its interest payments and/or the face value of the bond. It is also called the default risk because this only occurs when the borrower defaults.
Fortunately, there are ways for you to avoid investing in bonds that will do this.
Every bond has a bond credit rating attached to it. This shows the credit worthiness of the issuing company or government, and are assigned by credit rating agencies. The three biggest agencies are Moody’s Investors Service, Standard & Poor’s (S&P), and Fitch Ratings, with a combined 95% market share.
Simply put, investment grade ratings range between AAA for prime bonds to BBB- (or Baa3 for Moody’s) for low grade bonds. Anything below this is either highly speculative and not investment grade, or actually near to or in default.
In 2011, S&P downgraded the U.S. credit rating for the first time to one notch below AAA. This was an incredible blow (if only symbolic) to the superpower image of the U.S. economy.
It is arguable whether this downgraded credit score had a real impact on the U.S. economy. It certainly temporarily damaged the U.S. stock indexes.
Generally such an impact increases borrowing costs.
2. Interest Rate Risk
The golden rule of bonds is that when interest rates rise, the price of bonds falls. Interest rate risk applies only if you have to sell your bond prior to maturity.
Let’s say the interest rate rises from 4% to 5%. Your bond just decreased in market value (not face value). If you try to sell your bond, you will likely have to sell your bond for less than what you paid for it.
You also have to compete with new bonds that are likely to have a higher coupon rate, which will further drive your selling price down.
3. Call Risk/Reinvestment Risk
The call risk is tied to the likelihood that the issuer will “call” (buy back) the bonds before maturity.
This would occur when interest rate fall (unlike with interest Rate Risk), and issuer realizes that they could be spending less money by issuing fresh bonds at a lower interest rate.
This puts the investor in an unfortunate situation as he will have to forgo any further interest payments as well having to reinvest his cash at a lower interest rate.
One way to avoid this risk is to buy (or negotiate) Call Protection. An issuer must declare whether a bond is callable as well as the precise terms around a call, but call protection ensures that the issuer is not able to call the bond.
Often a callable bond will pay a higher coupon rate to compensate for the increase in risk.
4. Inflation Risk
If an investor experiences a rise in inflation (or cost of living), his returns future purchasing power will be eroded over time.
Although unlikely, if inflation increased enough an investor could experience a negative rate of return. The longer term the bond, the more susceptible it is to inflation risk.
5. Downgrade Risk
If a company or government that has issued bonds experiences a ratings downgrade, the market value of its issued bonds will decrease.
This naturally is unattractive to people who have invested in case they would like to sell the bond at any time.
6. Liquidity Risk
With government bonds, because of the U.S. Governments high credit rating, there will always be a strong market. These types of bonds don’t really experience liquidity risk, but corporate bonds carry this risk.
At any given moment, there is the possibility that the market for a particular bond will thin out and it will become difficult for an investor to sell his bonds.
This results in a decrease in prices of that type of bond to try to attract more buyers.