Question

Q1] List and briefly describe 3 major risks in bond investing.

Q2] Which class of bonds is not affected by one of the three major risks in bond investing listed in Q1, and which specific risk is it?

Q3] What is the bond market’s single main mechanism for incorporating risks in bonds?

Q4] How is the bond market’s mechanism listed in Q3 related to bond prices? Include a brief description of how it affects or interacts with bond prices.

Answer 1

Q1] List and briefly describe 3 major risks in bond investing.

The 3 major risks involved while investing in bonds are:

1. Interest Rate Risk: Since interest rates in the market have a contrasting effect on the bond prices, there tends to be more risks involved where the bonds are trading in a country with high fluctuations in interest rates. This may cause frequent changes in the bond prices making it difficult to predict in the long run (more specifically if the bonds need to be sold before its maturity).

2. Market Risk: If there is a change in the market value of all the bonds or an impact of the change in the economy, it poses a great risk to the bondholders. A lot of market risk depends on macro economic conditions that have a direct impact on the bond market. E.g. any change in the infrastructure industry may affect all the Infrastructure bonds across the market.

3. Credit Risk: The risk related to the ability to get the return on the investment is usually referred as Credit Risk. For bonds, investor are equally concerned like holding the stocks i.e. whether there is a good probability that the bond would not default and they are able to exercise their right to sell it.

Q2] Which class of bonds is not affected by one of the three major risks in bond investing listed in Q1, and which specific risk is it?

One of the three major risks in bond investments is Credit Risk since other risks allow less flexibility to the bond holder to manage the risk environment. Since bonds are primarily divided into Senior Bonds and Subordinated Bonds based on the ratings i.e. Senior Bonds consist of Highly rated bonds while Subordinated Bonds usually consists of the remaining bonds including below investment grade bonds.

Q3] What is the bond market’s single main mechanism for incorporating risks in bonds?

The single main mechanism for incorporating risks is Assigning Credit Ratings to individual bonds. These services are provided by the credit rating agencies like Standard & Poor's, Moody's and Fitch. The ratings usually range from AAA, A to C, C- or D depending on the credit rating agency's standards. The ratings help the investor bifurcate the high risk bonds with the low risk ones.

Q4] How is the bond market’s mechanism listed in Q3 related to bond prices? Include a brief description of how it affects or interacts with bond prices.

The ratings allocated to the bonds have a direct impact on the bond price. Since the subordinated or low investment grade bonds carry higher risk, they tend to offer better returns to justify the risks involved in the investments. Hence, the prices change based on the market fluctuations if the equity portion of the capital structure in the bonds takes precedence over the debt structure. E.g. For Community Choice Financial Inc. bond (Rated Caa3), the current yield is 58.10% with the current price of $80.65. On a similar note, a BMW US CAP 14/20 MTN bond (Rated A1) shows a relatively stable yield of 2.92% with the current price of $101.55.