Bond Investing Guide 3: Risks in Bond investing
October 26, 2009
This is now Part 3 of our series on How to Invest in Bonds.
Like any other financial instrument, a bond also has risks. Compared to other investment classes such as stocks or real estate, however, the risk in bonds is generally lower.
Here are the specific types of risks in bond investing.
Reinvestment risk is the risk that the bondholder will reinvest the cash flows received from a bond at lower interest rates. This usually happens when coupon interest payments have been received or when a bond is called or when it is prepaid and interest rates have declined in the economy causing the bondholder to lose out on the higher interest rate of the original bond.
A specific type of reinvestment risk is call risk, or the risk that the bond issuer will call the bond causing the bondholder to reinvest the payment received at lower rates . Some bonds are callable, meaning, the issuer of a bond has the option to “pre-terminate” the bond prior to maturity date. This usually happens when interest rates have fallen. Since the issuer can simply make a new bond issue at lower interest rates, it will benefit greatly by “calling” or “pre-terminating” the bond. When this happens, the bondholder receives payment but is now at risk to reinvest the received funds in bonds that pay lower interest rates.
Another specific example of reinvestment risk is prepayment risk, wherein the bond issuer returns the principal at an early, unscheduled date to take advantage of declining interest rates in the economy. When this happens, the bondholder is at risk to reinvest the returned principal in other bonds that pay lower interest rates.
Most bonds pay regular coupon payments, in most cases, annually or semiannually. Bondholders may lose on the “value of money” if the inflation rate in the economy is rising. For example, if the inflation rate in the Philippines rose to 10% from 2008 to 2009, a product being sold for P1,000 in 2008 will now cost P1,100 in 2009. A bondholder receiving P1,000 coupon interest annually won’t have the same purchasing power in 2009 compared to 2008. This risk that the increasing prices caused by a higher inflation rate will decrease the amount of real goods and services that bond payments will be able to purchase is called inflation risk.
Exchange Rate Risk
Exchange rate risk emerges when a bond makes payments in a foreign currency. For a Filipino investor who purchases a bond that pays coupon interest in US Dollar, a depreciation of the Dollar versus the Philippine Peso will reduce the returns to the peso-based investor. For example, if the dollar depreciates from an exchange rate of US$1.00 = Php50.00 to US$1.00 = Php48.00, a peso-based investor receiving coupon interest of $100 annually will receive less money after converting the dollar interest to peso.
Bonds with high credit rating are generally considered low-risk. If they are “downgraded” to a lower credit rating, they are assumed to be riskier than before. Investors of a downgraded bond will be faced with a higher risk of default and lower price of the bond. This is downgrade risk.
Bonds issued by a sovereign entity (more specifically, a country) are almost always low-risk. That’s because they can always raise taxes or print more money just to be able to pay its bond obligations. If, however, the country’s attitude towards repayment changes or its ability to repay worsens, the government bond becomes riskier. This risk is called sovereign risk.
Any risk outside the risks of financial markets which can have a sudden and substantial financial impact on the bond issuer’s financial condition is called event risk. For example, new regulations on clean air requirements, storms that destroyed warehouses, or multi-million dollar theft by the CEO may cause companies to incur losses which can reduce the cash available for bondolders.
After learning the risks of bond investing, you’re almost ready to make your first bond investment.
Up next: Types of Bond Investments and How to Invest in Bonds in the Philippines