What are the risks of investing in a bond?
As compared to other financial assets or securities fixed income securities are considered to be less risky. Though they are less risky, they are not entirely risk-free securities. Therefore, the investment in bonds is a function of various types and sources of risk. The actual return from a bond may differ from the expected return due to defalcation or changes in the market interest rate. Both systematic and unsystematic risks can influence the return from investments in bonds.
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However, The major risks involved in investments in the bond are default risk and interest rate risk.
Default risk refers to the failures of the company to repay the principal and/or interest thereon on the stipulated dates. Inefficient financial performance and management inefficacy lead to default risk. Default risk arises due to the nonpayment of the whole or a part of interest and principal. In such a situation, investors in bonds suffer losses that reduce their return from bonds. Through credit rating, such risk can be identified and measured. Credit rating is a process of qualitative analysis of the company’s business and management and quantitative analysis of the company’s financial performance.
Since the price of a bond rarely moves in financial markets, the major income from the bond represents the coupon interest rates. An investor in bond generally receives these interests annually or semi-annually. Hence, the investors can reinvest their interest amounts at the prevailing market interest rate so that interest on principal begets interest. An investor can do so, so long as he holds the security. The investor can sell the bond off at a price that may be equal to the face value. During the holding period, market interest rates may change. If the interest rate increases, the investor would be able to reinvest the annual interest earned from the bond at a higher rate which will maximize the return. In addition to that bond, the price will fall below its face value as the market interest rate moves up.
Therefore, an investor would suffer a loss if he sells the bond. If the loss on sale exceeds the gain on reinvestment, the investor will suffer a net loss on account of the rise in the market interest rate. In contrast, if the interest rate declines, the opposite dimension will exist. The investors have to reinvest the amount of interest at a lower than what was expected. Since the market interest declines, the bond price will move above the face value because the demand for that bond would become high as its rate of return is higher. Under these circumstances, the investors would incur lose in reinvesting the interest while they will gain on selling the bond. Investors in bond experience variations in the expected rate of return because of the changes in the market interest rate.
This variability in return is termed as interest rate risk. Interest rate risk is the result of two components like reinvestment of annual interest and the capital gains or losses on the sale of the bond at the end of the holding period. When the market interest rises, there is the possibility of making gains from reinvestment of interest but there may exist a lose on sale of the bond and vice versa. However, reinvestment risk and price risk are the decomposition s interest rate risk.
Both reinvestment risk and price risk have an opposite effect on the return of the bond. The investor can eliminate interest rate risk by holding the bond for its duration. If the holding period significantly differs from the duration of the bond, interest rate risk will exist for the bond.
Read More: Bond Pricing Theorems
What are the risks of investing in a bond.