The investors in bonds may also face event risk, i.e., the risk that the issuer will not be able to meet its interest and principal payment obligations due to a major event that impacts its financial condition. There are three broad categories of event risk:
- A natural disaster such as an earthquake, a flood or fire in the factory. As an example, imagine an earthquake destroys lots of property in a region. The bonds issued by insurers in that area will be hit because these insurers will have to make huge settlements for the policyholders.
- Merger and Acquisition or Corporate Restructuring: In such an event the company may face ratings downgrade exposing the company to downgrade risk. The company’s overall debt burden may increase due to either issuing new debt or debt that comes as a part of takeover.
- Regulatory changes such as imposition of a new tax or government’s decision to divest from certain securities can also impair an issuer’s ability to meet its obligations. Regulatory risk can come in a variety of forms and affects almost all companies.
Sovereign risk occurs in bonds held by a portfolio manager that are issued by foreign entities, for example, an American investor holding a bond issued by Japanese Government bond. The risk occurs due to the fact that the foreign government may default on its obligation, or takes some action that restricts the issuer to meet its bond obligations. Sovereign risk can take primarily two forms: 1) the foreign government is just unwilling to pay its debt (repudiation). 2) the government is unable to pay due to unfavourable economic conditions.