Risks Associated With Bonds Flashcards
Credit risk/default risk
The risk the issuer cannot pay interest and principal. Measured by credit agencies
Treasury bond rating
Because they are issued by US gov they have AAA rating i.e. highest rating (no credit risk)
S&P rating
Investment grade - AAA to BBB
Speculative grade - BB to C
Can adjust rating slightly by adding + or -
Moodys rating
Investment grade - Aaa to Baa
Speculative grade - Ba to C
Can change slightly by adding 1,2,3 ranking
Junk bonds
Below investment grade bonds aka high yields
BB/Ba is highest C/C is lowest
Interest rate risk/
Market risk
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
Variable rate bonds/
Adjustable rate bonds
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
Price volatility
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
Long duration bond
Long maturity, low coupon
Price sensitive bond
Long term zero coupon bonds are most volatile
Short duration bond
Short maturity, high coupon
Price stable bond
Capital risk
The risk that investors lose money
Most prevalent in high yield (junk) bonds
Purchasing power risk/
Inflation risk
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
Marketability risk
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
Liquidity risk
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
Legislative risk
The risk that new laws could reduce the value of a security e.g. new tax laws. Big issue for munis
Call risk
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.
Business risk
The risk that a business may underperform. Can be evaluated by examining company financial records. Can be reduced by diversification
Prepayment risk
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
Reinvestment risk
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
Currency risk
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
Political risk
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
Nonsystematic risk
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
Systematic risk
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
