Question

What are the major risks to investors when investing in bonds?

Explain with examples.

Answer 1

Bonds are generally considered to be a safer asset class than equities. However, bonds carry their own unique set of risks which must be taken into account by every bond investor.

The primary risks that bonds carry as an asset class are as follows:-

1) Interest rate risks: Bonds carry a certain coupon rate based on which investors make interest income. However, if after the issue of bonds, the benchmark interest rates in the economy go up, the interest rate of bonds will not be competitive to the market. Further, if the benchmark interest rates go up due to high inflation, the bonds' interest rates may not be enough even to cover inflation.

For example: ABC inc. issues 20 year bonds at 5% coupon rate while the benchmark long term interest rates in the economy are 4%. After 2 years of the issue, inflationary pressures forces Federal Reserve to increase long term interest rates to 6%, post which new bonds in the market that are comparative to the risk profile of ABC's bonds are being issued with a coupon rate of 7.5%. This means that investors of ABC bonds are not getting competitive interest rates on their bond investments and hence, the interest rate risks they have exposure to.

2) Market price risks: While all bonds have a specific maturity value that a company must pay on the bond maturity, it doesn't mean that bond investors carry no risk of capital loss. Bonds are valued in the market based on prevailing interest rates in the economy. When interest rates go up, the bond prices go down to adjust their interest yields higher in line with the increased benchmark interest rates. Similarly, when interest rates go down, bond prices go up to adjust their interest yields downwards in line with decreased interest rates.

Therefore, if an investor has to sell his bond investments before their maturity, there is a risk that he might have to sell them at prices lower than what he paid for the bond and hence could incur a capital loss

For example: An investor invests in 20 year bonds of XYZ inc. with 5% coupon rates and issued at par of $100 per bond. After 5 years of investment, the interest rates in the economy go up which makes bond price go down to $60 per bond so that its yield goes up in line with increased interest rates. Now, if the investor wants to liquidate his investments before maturity, he will have to take capital loss on his investment.