Saturday, November 14, 2009

Risks Involved in Investing in Bonds

Bonds are one of the most preferred investment instruments for the risk averse investor who wants a decent return on investment (ROI) and capital preservation at the same time. Bonds are debt obligations which pay out a fixed interest on the invested sum and pay back the whole invested principal at maturity. Unfortunately, Bonds are not so straight forward as they might sound. There are many risks involved in investing in Bonds. These risks can cause losses to the investors bond portfolio and defeat the whole purpose of capital preservation.

Some of the risks involved in investing in Bonds are:

1. Interest Rate Risk
2. Re-investment Risk
3. Call Risk
4. Default Risk &
5. Inflation Risk

Interest Rate Risk:

This is the most or well known risk in the bond market. This refers to the risk that bond prices will fall as the interest rates in the market rise. Bond prices are inversely proportional to the prevailing interest rates in the market. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a fixed period. If the market interest rate rises from the date of the bond's purchase, the bond's price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond. The investor would end up suffering losses if he wishes to liquidate his holdings at that point of time.

Market interest rates are a function of several factors such as the demand for, and supply of, money in the economy, the inflation rate, the stage that the business cycle is in as well as the government's monetary and fiscal policies.

Reinvestment Risk

This refers to the risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120 (12%*$1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond. If the investor has chosen reinvestment as an option, he would end up hurting his investment.

Call Risk

This refers to the risk that a bond will be called by its issuer. Callable bonds have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs. If an investor has exposure to such callable bonds, the bond issuer can retire the bond and reissue fresh ones, reducing his debt cost, thereby damaging the return prospects for the investor

Default Risk

The risk that the bond's issuer will be unable to pay the contractual interest or principal on the bond in a timely manner, or at all. This is one of the serious risk factors that need to be considered before investing in a bond. The main aim behind investing in bonds is capital preservation and if you invest in a company that is on the verge of going bankrupt, the investment is as good as flushing it down the drain. To help investors who do not have the time or the means to research into such instruments, Credit ratings services such as Moody's, Standard & Poor's and Fitch give credit ratings to bond issues, which helps to give investors an idea of how likely it is that a payment default will occur. For example, most federal governments have very high credit ratings (AAA); they can raise taxes or print money to pay debts, making default unlikely. However, small, emerging companies have some of the worst credit (BB and lower). They are much more likely to default on their bond payments, in which case bondholders will likely lose all or most of their investment. Investing in high rating instruments is a wise choice rather than choosing ones with lower ratings. But, there is a catch here, lower rating bonds usually offer higher ROI when compared to the higher rating ones. The Risk-Return trade off comes into picture here. To attract more investors, companies with a lower credit rating usually offer higher interest rates which might tempt the high risk investor to give it a try.

Inflation Risk

The risk that the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception. For example, if an investor purchases a 5% fixed bond and then inflation rises to 10% a year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted periodically to match inflation rates, limiting investors' exposure to inflation risk.

Happy Investing!!!
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