Risks Of Bonds

Question 1

List generic risks of bonds

Answer 1

Default risk
Issue specific risk
Market risk 
Inflation risk
Interest rate risk 
Maturity risk
Event risk 
Fiscal and currency risk
Commissions and spreads

Question 2

Outline default risks and ways to mitigate

Answer 2

Issuer fails to repay capital @ maturity or coupon payments as they fall due

Non payment fault

Credit risk

Mitigate

• risk adverse investors purchase gilts or investment grade
• be aware of credit rating agencies for specific bond issues
• gilts risk of default is nil
• if co goes into liquidation bondholder gets nil as no assets or liabilities

Question 3

Outline issue specific risk and how to Mitigate

Answer 3

I.e call facility

Issues relating to Co/ country

Mitigate

• Investors must read bond prospectus carefully
• contingency plans to reduce losses
• caution not to buy callable bonds in sec market at lower price (close to call date)

Question 4

Outline market risk and ways to mitigate

Answer 4

MP of bond changes

Investors purchase directly in pri or sec markets @ specific price and yield

In event have to sell due to unforeseen circumstances they must accept prevailing market price (could make profit or loss)

Mitigate
-diversify holdings with range of bonds in portfolio

Question 5

Outline inflation risk and how to mitigate

Answer 5

Conventional bonds only

longer term bonds greater risk inflation will erode value of coupon and redemption amount

Purchasing power of int drops

Mitigate
-buy index linked bonds

Question 6

Outline int rate risk and how to mitigate

Answer 6

External int rates rise and investor has lower foxed bond, bond price will fall as investors switch alternative products

Variable bonds and Int rates falls investors switch bonds

Higher int rates = greater risk perceived

-if rates rise above bond rate, bond rates become less competitive and MP falls / vise versa If rates fall below bond becomes attractive and prices rise again

Question 7

Outline maturity risk

Answer 7

Longer bonds have greater risks due to uncertainty in future

Higher coupons for longer dated bonds

Question 8

Outline event risk

Answer 8

Particular event affects business (capital restructuring impacts bond value)

Corp issuer becomes target of leveraged buy out therefore Increasing risk of lending any money to Co (external management acquire control of Co using external finance)

Question 9

Outline fiscal and currency risks

Answer 9

Change in tax

Fluctuations in currency

Risk of exchange controls for markets

Risk of punitive tax (extremely high) either domestic or overseas (increase withholding tax)

If currencies depreciate could impact negatively / receive cap amount but may be insufficient to match foreign currency liability when converted to domestic currency

Question 10

Outline commissions and spread

Answer 10

Care exercised regarding commissions and other costs

Wide spreads could impact profitability