Tuesday, May 19, 2009

Bonds, Not Risk Free

A common misconception (although probably not any more with all the bankruptcy going on recently) is that bonds are "safe". While it is true that they are "safer" than their comparable equities (debt has senior claims in bankruptcy, but tends to be cut down proportionally with junior tranches in restructuring), they are not perfectly "safe" (the only investment considered safe are US Treasuries which are considered to be default free and used as a proxy for the risk free rate, RFR).

So what are the different forms of risk that investors need to be aware of when making investment decisions in fixed income securities?
  • Interest rate risk. As interest rates in the market move down (up), price goes up (down).
  • Inflation risk. The risk of unexpected inflation which affects the real interest rate for a given nominal interest rate.
  • Reinvestment risk. For bonds with coupons, if interest rates decline, than the interest earned from coupon payments will also decline (yield to maturity, YTM, assumes that all cash flows are invested at the same rate).
  • Prepayment risk. A variation of interest rate and reinvestment risk. If rates fall, borrowers will prepay their obligations and investors will reinvest at the lower rate.
  • Credit risk. The risk of an event having an adverse affect on the issuers credit rating (thereby reflecting a change in the credit spread). This could be the company defaulting on an obligation (bankruptcy) or having an issue downgraded.
  • Liquidity risk. If a security is not actively traded, there is will be a transaction premium to sell the bond (a higher yield will be required).
  • Volatility risk. The risk for fixed-income securities that have embedded options. Changes in volatility affect the value of the embedded options and therefore the nominal yield spread and bond price.
  • Call risk. If the bond has a call option, there is a risk that the bond will be called, limiting the value (price) of the bond.
  • Exchange-rate risk. For bonds issued in foreign currency, movement in either currency relative to the other will affect the value of the bond (as it does with equities in foreign markets)
  • Sovereign risk. The risk that a foreign countries government takes actions or is affected by events which adversely affect the value of the bond.
Understanding the risks inherent in a bond's structure allows bond portfolio managers to construct positions which have predictably less volatility while maximizing returns.

1 comment:

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