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Investment - Risk of Investing in Debt Securities
Investing in bonds comes with a lot of dangers, but how do these risks affect the price of a bond on the market? The yield to maturity on a bond is a function of its maturity and risk.
In principle, two bonds with the same maturity and risk should trade at prices that offer nearly the same yield to maturity. For example, two five-year bonds with the same liquidity and the same credit rating will trade at essentially identical yields to maturity.
Low-risk bonds, such as many government bonds, trade at substantially lower yields to maturity, which suggest relatively higher prices. Similarly, high-risk bonds, such as high-yield (or non-investment-grade) bonds, trade at substantially higher yields to maturity, which suggest significantly lower prices. Relative to secured debt, subordinated debt securities offer higher yields to maturity, which reflect their increased default risk.
Credit Risk
The risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal.
Interest Rate Risk
The danger that interest rates may climb, leading the price of fixed-rate and zero-coupon bonds to decline.
Inflation Risk
The danger that the purchasing power of the coupon payments and final principal payment would diminish with inflation.
Liquidity Risk
The risk of being unable to sell a bond before to the maturity date without having to accept a considerable discount to market value.
Reinvestment Risk
The risk that coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
Call Risk
The risk that the issuer will buy back (or call) the bond issue prior to maturity through the exercise of a call clause.
Credit Risk
Credit risk, commonly referred to as default risk, is the risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal. The issuer may encounter financial trouble and consequently not have the money available to make the promised interest and/or principal payments. In this circumstance, bondholders may lose a large proportion of their invested capital.
It is vital to highlight that credit risk can damage bondholders even when the company does not actually default on its payments.
For example, if market participants fear that a particular bond issuer will not be able to make its promised bond payments because of unfavorable business or general economic conditions, the probability of future default would grow, and the bond price will likely decline in the market.
Consequently, investors owning that particular bond will be vulnerable to a price decrease and a potential loss of money if they seek to sell the bond.
Credit Rating
Investors may be able to estimate the credit risk of a bond by checking its credit rating. Independent credit rating agencies examine the credit quality of certain bonds and assign them ratings depending on the creditworthiness of the issuer.
The following display presents the credit ratings systems of Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings.
Based on credit risk, bonds are classified as investment-grade bonds (those in the shaded part of the exhibit) or non-investment-grade bonds (those in the non-shaded area of the exhibit).
Many government regulators often mandate that certain investors, such as insurance companies and pension funds, largely restrict their investments to bonds that are investment grade (e.g., bonds with a high degree of creditworthiness and minimal risk of default).
Non-investment-grade bonds are frequently referred to as high-yield bonds or junk bonds. They are dubbed trash bonds because they are less creditworthy and have a greater probability of default. Investors in these bonds prefer the name high-yield bonds, which acknowledges the higher yields (anticipated profits) on these bonds due of the higher level of risk. Recall that the riskier the borrower — or the less assured the borrower’s apparent capacity to repay the loan — the greater the level of interest demanded by the lender.
Credit rating agencies award a bond rating at the time of issue, but they also assess the rating and may change a bond’s credit rating over time depending on the issuer’s perceived creditworthiness. An improvement in credit rating is referred to as an upgrade, and a fall in credit rating is referred to as a downgrade.
A high credit rating affords a bond issuer two primary benefits: the capacity to issue debt securities at a cheaper interest rate and the opportunity to access a bigger pool of investors.
The wider pool of investors will include institutional investors that must hold major amounts of their investment assets in investment-grade bonds.
Credit Spreads
US Treasuries and government bonds of some developed and emerging countries are considered safe instruments that bear minimal default risk. Consequently, relative to these government bonds, rates on other bonds are often greater.
Investors usually refer to the difference between a hazardous bond’s yield to maturity and the yield to maturity on a government bond with the same maturity as the risky bond’s credit spread. The credit spread tells the investor how much extra yield is being offered for investing in a bond that has a higher likelihood of default.
The following is an example of calculating and analyzing a credit spread.
Consider a corporate bond with a remaining maturity of 30 years. The bond’s coupon rate is 5.2%. Currently, the bond is selling at a price of USD1,185.32, providing a yield to maturity of 4.10%. The yield to maturity on a 30-year Treasury bond is 3.22%
The corporate bond’s credit spread over a 30-year Treasury is 4.10% – 3.22% = 0.88%, or 88 bps. The extra yield, or credit spread, supplied by the corporate bond acts as compensation to the investor for incurring a higher risk for investing in the corporate bond relative to the safer Treasury bond.
Higher-risk bonds, such as trash bonds, trade at wider credit spreads because of their higher default risk. Similarly, lower-risk bonds trade at narrower credit spreads relative to high-risk bonds. Credit spreads enable investors to analyze yield disparities across bonds of various credit quality.
If a bond is judged to have gotten riskier, its price will fall and its yield will rise, which will likely result in a widening of the bond’s credit spread relative to a government bond with the same term. Similarly, a bond seen to have experienced an increase in credit quality may have its price rise and its yield fall, possibly resulting in a narrower credit spread relative to a comparable government bond.
Interest Rate Risk
Interest rate risk is the risk that interest rates will vary. Interest rate risk usually refers to the risk associated with drops in bond prices coming from rises in interest rates (i.e., yields to maturity). This risk is particularly important to fixed-rate bonds and zero-coupon bonds.
Bond prices and interest rates are inversely connected; that is, bond prices increase as interest rates decrease, and bond prices decrease as interest rates increase.
Prices of zero-coupon and fixed-rate bonds can decrease dramatically in an environment of rising interest rates. But because coupon rates on floating-rate bonds are reset to current market interest rates at each payment date, floating-rate bonds exhibit less interest rate risk while interest rates are rising. But a floating-rate bond may display interest rate risk in an environment of dropping interest rates because investors receive less coupon income when the bond’s coupon rate is reset to a lower rate.
A commonly used metric of interest rate risk is duration, which quantifies the sensitivity of a bond’s price to changes in its yield to maturity.
Specifically, a bond’s duration is the estimated percentage change in price for a 100 basis point change in the bond’s yield to maturity.
For example, if a bond’s length is 7.0, then the bond’s price is projected to increase by 7% for every 100 basis point fall in its yield to maturity (or conversely, to decline by 7% for every 100 basis point increase).
Inflation Risk
Nearly all debt securities expose investors to inflation risk because the promised interest payments and final principal payment from most debt securities are nominal quantities – that is, the amounts do not vary with inflation.
Unfortunately, as inflation makes things and services more expensive over time, the purchasing power of the coupon payments and the final principal payment on most bonds falls with time.
Floating-rate bonds partially guard against inflation because the coupon rate fluctuates over time.
They provide no protection, however, against the loss of purchasing power of the principal payment.
Investors that are concerned about inflation and seek protection against it may want to invest in inflation-linked bonds, which adjust the main (par) value for inflation. Because the coupon payment is based on the par value, the coupon payment also changes with inflation. Call Risk
Call risk, commonly referred to as prepayment risk, refers to the risk that the issuer will purchase back (redeem or call) the bond issuance prior to maturity through the execution of a call provision.
If interest rates fall, issuers may execute the call provision, therefore bondholders will have to reinvest the funds in bonds with lower coupon rates. Callable bonds, and most mortgage-backed securities based on loans that allow the borrowers to make loan prepayments in advance of their maturity date, are exposed to prepayment risk.
Liquidity Risk
Liquidity risk refers to the risk of being unable to sell a bond prior to the maturity date without having to accept a large discount to market value. Bonds that do not trade regularly display high liquidity risk.
Investors who want to sell their somewhat illiquid bonds face higher liquidity risk than investors with bonds that trade more regularly.
Reinvestment Risk
Reinvestment risk refers to the fact that in a period of decreasing interest rates, the coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
If market interest rates fall after a bond is issued, bondholders will most likely have to reinvest the income received on the bond (the coupon payment) at the current lower interest rates.
Investing in bonds comes with a lot of dangers, but how do these risks affect the price of a bond on the market? The yield to maturity on a bond is a function of its maturity and risk.
In principle, two bonds with the same maturity and risk should trade at prices that offer nearly the same yield to maturity. For example, two five-year bonds with the same liquidity and the same credit rating will trade at essentially identical yields to maturity.
Low-risk bonds, such as many government bonds, trade at substantially lower yields to maturity, which suggest relatively higher prices. Similarly, high-risk bonds, such as high-yield (or non-investment-grade) bonds, trade at substantially higher yields to maturity, which suggest significantly lower prices. Relative to secured debt, subordinated debt securities offer higher yields to maturity, which reflect their increased default risk.
Credit Risk
The risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal.
Interest Rate Risk
The danger that interest rates may climb, leading the price of fixed-rate and zero-coupon bonds to decline.
Inflation Risk
The danger that the purchasing power of the coupon payments and final principal payment would diminish with inflation.
Liquidity Risk
The risk of being unable to sell a bond before to the maturity date without having to accept a considerable discount to market value.
Reinvestment Risk
The risk that coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
Call Risk
The risk that the issuer will buy back (or call) the bond issue prior to maturity through the exercise of a call clause.
Credit Risk
Credit risk, commonly referred to as default risk, is the risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal. The issuer may encounter financial trouble and consequently not have the money available to make the promised interest and/or principal payments. In this circumstance, bondholders may lose a large proportion of their invested capital.
It is vital to highlight that credit risk can damage bondholders even when the company does not actually default on its payments.
For example, if market participants fear that a particular bond issuer will not be able to make its promised bond payments because of unfavorable business or general economic conditions, the probability of future default would grow, and the bond price will likely decline in the market.
Consequently, investors owning that particular bond will be vulnerable to a price decrease and a potential loss of money if they seek to sell the bond.
Credit Rating
Investors may be able to estimate the credit risk of a bond by checking its credit rating. Independent credit rating agencies examine the credit quality of certain bonds and assign them ratings depending on the creditworthiness of the issuer.
The following display presents the credit ratings systems of Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings.
Based on credit risk, bonds are classified as investment-grade bonds (those in the shaded part of the exhibit) or non-investment-grade bonds (those in the non-shaded area of the exhibit).
Many government regulators often mandate that certain investors, such as insurance companies and pension funds, largely restrict their investments to bonds that are investment grade (e.g., bonds with a high degree of creditworthiness and minimal risk of default).
Non-investment-grade bonds are frequently referred to as high-yield bonds or junk bonds. They are dubbed trash bonds because they are less creditworthy and have a greater probability of default. Investors in these bonds prefer the name high-yield bonds, which acknowledges the higher yields (anticipated profits) on these bonds due of the higher level of risk. Recall that the riskier the borrower — or the less assured the borrower’s apparent capacity to repay the loan — the greater the level of interest demanded by the lender.
Credit rating agencies award a bond rating at the time of issue, but they also assess the rating and may change a bond’s credit rating over time depending on the issuer’s perceived creditworthiness. An improvement in credit rating is referred to as an upgrade, and a fall in credit rating is referred to as a downgrade.
A high credit rating affords a bond issuer two primary benefits: the capacity to issue debt securities at a cheaper interest rate and the opportunity to access a bigger pool of investors.
The wider pool of investors will include institutional investors that must hold major amounts of their investment assets in investment-grade bonds.
Credit Spreads
US Treasuries and government bonds of some developed and emerging countries are considered safe instruments that bear minimal default risk. Consequently, relative to these government bonds, rates on other bonds are often greater.
Investors usually refer to the difference between a hazardous bond’s yield to maturity and the yield to maturity on a government bond with the same maturity as the risky bond’s credit spread. The credit spread tells the investor how much extra yield is being offered for investing in a bond that has a higher likelihood of default.
The following is an example of calculating and analyzing a credit spread.
Consider a corporate bond with a remaining maturity of 30 years. The bond’s coupon rate is 5.2%. Currently, the bond is selling at a price of USD1,185.32, providing a yield to maturity of 4.10%. The yield to maturity on a 30-year Treasury bond is 3.22%
The corporate bond’s credit spread over a 30-year Treasury is 4.10% – 3.22% = 0.88%, or 88 bps. The extra yield, or credit spread, supplied by the corporate bond acts as compensation to the investor for incurring a higher risk for investing in the corporate bond relative to the safer Treasury bond.
Higher-risk bonds, such as trash bonds, trade at wider credit spreads because of their higher default risk. Similarly, lower-risk bonds trade at narrower credit spreads relative to high-risk bonds. Credit spreads enable investors to analyze yield disparities across bonds of various credit quality.
If a bond is judged to have gotten riskier, its price will fall and its yield will rise, which will likely result in a widening of the bond’s credit spread relative to a government bond with the same term. Similarly, a bond seen to have experienced an increase in credit quality may have its price rise and its yield fall, possibly resulting in a narrower credit spread relative to a comparable government bond.
Interest Rate Risk
Interest rate risk is the risk that interest rates will vary. Interest rate risk usually refers to the risk associated with drops in bond prices coming from rises in interest rates (i.e., yields to maturity). This risk is particularly important to fixed-rate bonds and zero-coupon bonds.
Bond prices and interest rates are inversely connected; that is, bond prices increase as interest rates decrease, and bond prices decrease as interest rates increase.
Prices of zero-coupon and fixed-rate bonds can decrease dramatically in an environment of rising interest rates. But because coupon rates on floating-rate bonds are reset to current market interest rates at each payment date, floating-rate bonds exhibit less interest rate risk while interest rates are rising. But a floating-rate bond may display interest rate risk in an environment of dropping interest rates because investors receive less coupon income when the bond’s coupon rate is reset to a lower rate.
A commonly used metric of interest rate risk is duration, which quantifies the sensitivity of a bond’s price to changes in its yield to maturity.
Specifically, a bond’s duration is the estimated percentage change in price for a 100 basis point change in the bond’s yield to maturity.
For example, if a bond’s length is 7.0, then the bond’s price is projected to increase by 7% for every 100 basis point fall in its yield to maturity (or conversely, to decline by 7% for every 100 basis point increase).
Inflation Risk
Nearly all debt securities expose investors to inflation risk because the promised interest payments and final principal payment from most debt securities are nominal quantities – that is, the amounts do not vary with inflation.
Unfortunately, as inflation makes things and services more expensive over time, the purchasing power of the coupon payments and the final principal payment on most bonds falls with time.
Floating-rate bonds partially guard against inflation because the coupon rate fluctuates over time.
They provide no protection, however, against the loss of purchasing power of the principal payment.
Investors that are concerned about inflation and seek protection against it may want to invest in inflation-linked bonds, which adjust the main (par) value for inflation. Because the coupon payment is based on the par value, the coupon payment also changes with inflation. Call Risk
Call risk, commonly referred to as prepayment risk, refers to the risk that the issuer will purchase back (redeem or call) the bond issuance prior to maturity through the execution of a call provision.
If interest rates fall, issuers may execute the call provision, therefore bondholders will have to reinvest the funds in bonds with lower coupon rates. Callable bonds, and most mortgage-backed securities based on loans that allow the borrowers to make loan prepayments in advance of their maturity date, are exposed to prepayment risk.
Liquidity Risk
Liquidity risk refers to the risk of being unable to sell a bond prior to the maturity date without having to accept a large discount to market value. Bonds that do not trade regularly display high liquidity risk.
Investors who want to sell their somewhat illiquid bonds face higher liquidity risk than investors with bonds that trade more regularly.
Reinvestment Risk
Reinvestment risk refers to the fact that in a period of decreasing interest rates, the coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
If market interest rates fall after a bond is issued, bondholders will most likely have to reinvest the income received on the bond (the coupon payment) at the current lower interest rates.
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