Question

What are some of the most important risks associated with bonds?

Answer 1

Some risks associated with bonds are:

1). Interest rate risk - Bond prices and interest rates are inversely related so if interest rates fall, bond prices increase. This happens because when interest rates fall down, investors want to invest in higher interest rates which are available on existing bonds so those bonds become in demand. As demand increases, bond prices rise.

2). Reinvestment risk - As interest rates fall, the coupon payments on the bonds being held, have to be reinvested at the lower rate. Thus, returns decrease.

3). Inflation risk - Since bond payments are fixed, change in inflation affects real returns as an increase in inflation will result in lower purchasing power.

4). Liquidity risk - Corporate bondholders may not be able to sell their bonds quickly enough if there is not enough trading in a particular bond. This can lead to volatile pricing and can impact returns on the bond.

5). Default risk - It is the risk that a company may not be able to fulfil its debt obligations due to poor performance or financial crunch.

6). Ratings downgrade risk - Most companies rely on ratings by major ratings agencies like S&P etc. to be able to raise debt at a reasonable cost. If a company's debt is downgraded then major lenders like banks will re-evaluate the company and can demand more interest rate for any future loans. This, in turn, can have a negative impact on the company's ability to meet its current debt obligations which in turn, can make it more difficult for current bondholders to sell their bonds, or sell it at a lower price.