Risks Associated With Bonds

Question 1

Credit risk/default risk

Answer 1

The risk the issuer cannot pay interest and principal. Measured by credit agencies

Question 2

Treasury bond rating

Answer 2

Because they are issued by US gov they have AAA rating i.e. highest rating (no credit risk)

Question 3

S&P rating

Answer 3

Investment grade - AAA to BBB
Speculative grade - BB to C
Can adjust rating slightly by adding + or -

Question 4

Moodys rating

Answer 4

Investment grade - Aaa to Baa
Speculative grade - Ba to C
Can change slightly by adding 1,2,3 ranking

Question 5

Junk bonds

Answer 5

Below investment grade bonds aka high yields
BB/Ba is highest C/C is lowest

Question 6

Interest rate risk/
Market risk

Answer 6

The risk that rising interest rates will cause bond prices to fall. Applies only to fixed rate interest securities.
Bonds with long term maturity, low interest rates or deep discount are most susceptible to this risk

Question 7

Variable rate bonds/
Adjustable rate bonds

Answer 7

They have an interest rate that is reset periodically to a market index. Their price usually stays close to par because their interest rates move with market rates. They do not have interest rate risk

Question 8

Price volatility

Answer 8

2 factors:
Time to maturity
Coupon rate

High coupon and short time to maturity are less volatile

Duration is indication of sensitivity to interest rate changes I.e. maturity + coupon factors combined

Question 9

Long duration bond

Answer 9

Long maturity, low coupon

Price sensitive bond

Long term zero coupon bonds are most volatile

Question 10

Short duration bond

Answer 10

Short maturity, high coupon

Price stable bond

Question 11

Capital risk

Answer 11

The risk that investors lose money

Most prevalent in high yield (junk) bonds

Question 12

Purchasing power risk/
Inflation risk

Answer 12

The risk that the investor can buy less with their money when the bond matures
Treasury Inflation Protected Securities TIPS give protection against this- issued by US gov

Question 13

Marketability risk

Answer 13

The risk the bond will be difficult to sell in the future e.g. because of issue size, number of traders in the market

This risk is non existent for Treasury bonds but is a concern for munis

Question 14

Liquidity risk

Answer 14

The risk that you might not be able to sell an investment quickly at a competitive price without high transaction costs. The longer the term and lower the quality the less liquidity. Short-term high-quality bonds are liquid

Question 15

Legislative risk

Answer 15

The risk that new laws could reduce the value of a security e.g. new tax laws. Big issue for munis

Question 16

Call risk

Answer 16

The risk that the bond may be called prior to maturity, forcing the investor to reinvest at a lower interest rate. Call risks increase as interest rates fall.

Question 17

Business risk

Answer 17

The risk that a business may underperform. Can be evaluated by examining company financial records. Can be reduced by diversification

Question 18

Prepayment risk

Answer 18

The risk that the investors principal will be repaid prior to maturity. This risk applies mainly to mortgage backed securities MBSs and occurs when interest rates fall. As rates fall mortgage holders refinance at lower rates resulting in the MBS investor receiving their principal back early

Question 19

Reinvestment risk

Answer 19

The risk that interest rates fall over the lifetime of the bond resulting in the investor having to reinvest the interest payments at a lower interest rate
Can avoid this risk by investing in zero coupon bonds

Question 20

Currency risk

Answer 20

The risk that the value of foreign currency in which the bond is denominated weakens causing the value to fall. This only applies to investments in foreign securities

Question 21

Political risk

Answer 21

The risk of investing in foreign countries that have weak political and legal systems. Something could happen that causes them to stop making bond payments

Question 22

Nonsystematic risk

Answer 22

Risks that are unique to individual securities, industries or countries I.e. don’t apply to the entire securities system e.g. credit risk or business risk. These can be lessened with diversification

Question 23

Systematic risk

Answer 23

Risks that apply to the entire market e.g. interest rate risks for bonds, market risk (market could crash) for stocks. Diversification wont protect you from this