Question

Explain the types of risk there are in Bonds, how do these apply to today's markets, also explain bond ratings, the different types and how these ratings affect pricing and yields of the bonds in use. Find examples of different rating comparable companies and post their yields and risks. Compare and contrast.

Answer 1

The three types of risks are:

1. Default risk: This is defined as the risk that arises if the bond issuing company defaults on either the interest or principal at maturity.

2. Interest rate risk: This is defined as the risk that arises from movement of interest rates. In long term bonds, higher interest rate means lower prices and vice-versa.

3. Inflation risk: This risk arises from the fact that interest rate are here to cover for inflation over the years. After payment of taxes are the interest rates enough to cover for inflation or would the value of money depreciate.

In today’s market, the US Fed is seen increasing interest rates and hence bond yields are moving up, So there is a rush of money from stocks and bonds and hence this reduces the prices of bonds which may result in lower return for long term bonds.

The different ratings that are given is based on the credit worthiness of the company issuing these bonds. If the company is very stable and there is very less risk it is awarded a AAA rating which is the highest. From here it goes down with AA, A , BBB, BB , B, C and D is the worst or default category bonds . D rated bonds are often called "Junk Bonds"

AAA bonds have lower interest rates which may only be slightly higher than the treasury bonds. The interest rates increases as we move down and Junk bonds have the highest interest rates.