Question

define and describe the most significant risks of bond investing

Answer 1

Answer:-

The most significant risks of bond investing are:-

Interest rate risk, Call risk, Yield curve risk, Prepayment risk, Reinvestment risk, Liquidity risk, Credit risk, Exchange rate risk, Volatility risk, Event risk and Sovereign risk.

Interest rate risk - The change in interest rates, by the central banks causes the values of bonds to change. The bond value falls when there is increase in the interest rates.

Call risk:- This happens for callable bonds when the bond is called back with fall in interest rates and the principal amount is reinvested at lower rates

Yield curve risk:- This refers to the relation of bond yields and maturity, when there is change in the shape of yield curve which causes changes in bonds with different maturities.

Prepayment risk:- This risk is associated with the prepayments needed for amortization of loans. The prepayments tend to increase with fall in interest rates.

Liquidity risk:- This risk arises when the bond is redeemed at a lower price because of lack of liquid market for that issue.

Credit risk:- This happens when the issuer will face financial problems which will decrease the creditworthiness thus decreasing the value of the bond

Exchange rate risk:- This risk arises by the fluctuating currency values between the two countries when the bond is issued by other country rather than the home country.

Volatility risk:- This risk is due to volatility in the interest rates awhich effects the values of embedded options like call options and put options.

Event risk:- This risk happens when there is some corporate event such as acquisition or some natural calamity  

Sovereign risk:- This risk arises when the bond is issued by sovereign country to the investors of home country.

Reinvestment risk:- This risk occurs when there reinvestment of principal of interest payments are reinvested at lower rates.