Lesson 3 of 17
Bonds are a lucrative investment class for investors and portfolio managers. However, just like any other investment, investing in bonds also has many risks associated with it. This article lists the key risks:
Interest Rate Risk: Bond prices are inversely related to interest rates. When interest rates rise, bond prices fall and vice versa.
Call and Prepayment Risk: Bonds can have embedded options such as an embedded call in which case the bond may be called back before maturity. Bonds may have prepayment risk, in cases where the underlying cash flow is backed by a loan pool.
Yield Curve Risk: The term structure of interest rates, or yield curve, may change causing the value of bond portfolio to change.
Reinvestment Risk: The yield-to-maturity (YTM) assumes that you will be able to reinvest the intermediate cash flows at the same yield. This may not always be possible and the investor may not realize the YTM.
Credit Risk: The investor is also exposed to credit risk in the form of default risk, credit spread risk, and downgrade risk.
Liquidity Risk: This is the risk that the investor may have to sell the bond at a price lower than the expected price. This is measured using bid-ask spread.
Exchange-rate Risk: Bonds with cash flows in foreign currency will add foreign exchange risk to the bond portfolio.
Volatility Risk: The higher is the expected yield volatility, the higher is the price of the bond.
Inflation Risk: The increase in inflation may wipe out the profits from the bond.
Event Risk: At times, the issuer may not be able to make the interest and principal payments on time due to events such as natural disasters, merger/acquisition, or a change in regulation. Such events collectively refer to event risk.
Sovereign Risk: Bonds issued by foreign entities also pose sovereign risk. The risk is that some action of the foreign government affects the bonds price or cash flows.
In the following articles, we will look at all these risks faced by a bond investor in detail.