Risk of bonds
When buying a bond, be it a government bond, corporate bond or any other type of bond, we must take into consideration that investing in them carry its own risk, no matter how safe the investment may look. This post seeks to analyze the types of risk that may be faced when investing in a bond; now let’s begin.
Interest rate risk
Interest rate risk is the uncertainty concerning bond value and prices due to interest rate fluctuations. The interest rate being discussed here is the market interest rate. The price or value of a bond is largely determined by the market interest rate. Market interest rate and the price of a bond tend to go in opposite directions. Meaning that if market interest rates rise, the price of a bond falls, and if market interest rate falls, the price of a bond rises. Why is this you may ask? Well, there is a simple logic to it. Many bonds pay a fixed rate of interest throughout their term. If the market interest rate rises, it means that investors can get newer bonds at higher interest rates because of the increased cost of borrowing. So investors stuck to the fixed interest rate of the lower paying bond lose out on new opportunities to hold similar high yield bonds. The opposite is the case for a lower market interest rate because investors of current bonds would have hedged themselves against new bonds which would be issued at low interest rates.
There are two types of interest rate risk. They are : Price risk and coupon reinvestment risk.
Price risk has to do with the risk of getting a lower price on the sale of bonds if not held to maturity. Let’s break this down; a bond usually starts off at a time period 0 to maybe 5 years, 10 years, 20 years and much more . Suppose we buy a zero coupon bond at 781.20 with a maturity of 10 years, a par value/face value of $1000 and a return (YTM) of 2.5 % (i.e. return if held to maturity). A yield to maturity is the average return you get within the period. While time is passing, interest rates are changing; by so doing, the price of the bond changes in response to interest rate changes. Supposing after 5 years, there is a financial need by the bond holder, and he needs to sell the bond in order to meet this need. There is an uncertainty in what the price of the bond would be 5 years from now. We know the price of $1000 would be received if held for the full 10 years; but we don’t know the price to be received if held for just 5 years instead of the full 10 years. This is what is called price risk.
Coupon Reinvestment risk
This is the risk to coupon paying bond. There is risk inherent in holding a coupon paying bond. Coupon is the annual interest rate of a bond, expressed as a percentage of its face value. Assuming we buy a bond for $1000, it has a face value of $1000, and Coupon payment is $60. When calculating the yield to maturity, we say it has a 6% YTM; but throughout the life of a bond, the YTM is not fixed because although the coupon payment is fixed, the price of a bond is determined by the market and economic conditions. For a coupon paying bond, it is difficult to determine the YTM of the bond because we do not know the return coupons would earn if re invested. This is what is called coupon reinvestment risk. So in analyzing the coupon re investment, if interest rates go up, it helps you because you earn a higher return on your coupons, but if you sell it, you might lose out on the potential of making higher returns. The reverse is the case when interest rates fall.
Government bonds are referred to as the safest bond one can get, because it is believed that no matter what a government would generate income to pay off bond holders when the bond matures. What of corporate bonds? Corporate bonds are bond issued by a corporation in order to raise financing. It is usually issued at a discount to the face value. It could be a zero coupon bond or a coupon paying bond. A bondholder purchases a corporate bond based on the belief that the corporation would be able to service its debt as at when due. A default risk is then the risk that the corporation will be unable to make the required payments on their debt obligations.
Frank Fabozzi., Martin Leibowitz., Fixed Income Analysis