The Risks Associated with Investing in Bonds

Investors have been pouring money into bonds since the stock market swoon that began the end of 2008. In fact, according to the Investment Company Institute, there has not been a single month over the past 17 months in which the net flow into bonds has been negative. This is hardly true for domestic and foreign equities.

So, what can we make of this? Investors have clearly become less willing to risk their funds in the stock market. They would rather invest in bonds even if yields are at historically low levels. The yield on the 10 year Treasury is around 3.5%.

But are bonds as safe as most investors seem to think? What are the risks associated with investing in bonds? Here’s a quick overview:

Interest rate risk: When interest rates rise, the value of bonds goes down. The reason for this is that bonds have fixed payments in the form of coupons and a final maturity value. When interest rates rise, these fixed payments become comparatively less valuable. The only way an investor would be willing to be a bond with a lower coupon payment would be if the price of the bond itself were less. This adjustment maintains the marketability of the bond.

Call risk: Some bonds are callable by the issuer. This means that they can be bought back from the bond holders prior to maturity. Issuers tend to call bonds when interest rates drop, because they can re-issue new debt at lower rates and thereby reduce their financing costs.

Prepayment risk: Some bonds allow the issuer to repay portion of the outstanding principal prior to maturity. If rates have dropped, the bond holder will likely be unable to reinvest these proceeds at the coupon rate of the bond.

Yield curve risk: The yield curve represents the relationship between market interest rates and the time to maturity of bonds. Changes in the yields of bonds with different maturities can change the shape of the yield curve. When yields change, prices change.

Reinvestment risk: Bond holders receive payments for providing (i.e. loaning) the bond issuer a principal sum. Investors are concerned with their ability to invest these payments at attractive rates. If market rates drop, reinvestment risk rises.

Default risk: This is the risk that the issuer of the debt will be unable to make the required payments. Default is the failure to maintain the terms of the debt obligation. Issuers perceived to have greater default risk are required to compensate lenders with higher coupon rates.

Credit spread risk: The spread is the difference between yields on Treasury securities and any non-Treasury securities that are otherwise identical. Treasury securities are risk free. All other securities carry some form of risk. The spread represents the risk that the investor takes on for investing in securities that are risky.

Downgrade risk: This is the risk that a credit rating agency will lower its rating on a particular issue. When this happens, the bond is considered riskier. In order to compensate investors for this additional risk, the price of the bond will fall.

Liquidity risk: Liquidity refers to the ability to quickly sell a security. Bonds that can be readily bought and sold with relatively low transaction costs are considered liquid. Investors tend to prefer bonds that are liquid. Bonds that are relatively illiquid are not as attractive and, as a consequence, will sell at lower prices.

Exchange rate risk: This risk is associated with bonds denominated in currency other than the U.S. dollar. Investors who exchange US$ into other currencies and the purchase bonds in those currencies are faced with additional risk of converting the foreign currency back to US$. If the US$ has gained value during the foreign bond holding period, the investor will lose money converting back to US$.

Volatility risk: Bonds with options (call options, prepayment options, and put options) are subject to volatility risk. Change in the volatility of interest rates affects the value of bonds depending on the type of option that are embedded. Imagine a put option on a bond. If volatility increases, the value of the put increases. . This increases the value of the bond.

Inflation risk: Inflation erodes purchasing power. Bond investors are faced with using fixed coupon payments to purchase goods and services that increase in cost over time. If inflation jumps unexpectedly, bond values will drop.

Event risk: Bonds can drop in value if an adverse event occurs. A natural disaster, a corporate change or a regulatory change could cause credit analysts to downgrade a bond. This will lead to a loss in bond value.

So, while investors seem to be rushing into bonds, one wonders how well they understand the risks of investing in these securities.

Sources: Investment Company Institute, CFA Institute