What are the risks for bond investors?
19 / 05 / 22
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Investing in bonds has long been considered one of the safest, especially if you hold securities to maturity. However, this comes with a number of risks.
The 2011/2012 sovereign debt crisis reminded us that even supposedly safest bonds, namely government bonds, can pose risk.
The long period of very low interest rates that we have been seeing for several years has reduced the attractiveness of investing in bonds, while creating additional risk for bondholders (in the event of a sharp increase in interest rates, a fall in bond prices can be fatal for holders of large portfolios ).
Default (or debtor) risk
When you lend money to someone, there is always a risk that they won't pay you back. This risk applies to bonds. It is called debtor risk or default risk. This risk naturally depends on the quality of the issuer.
For example, for corporate bonds it will be higher than for government bonds.
The issuer's debt repayment probability is measured, among other things, by rating agencies. The latter analyze the economic and financial position of each issuer and assign a rating to each financial product, including bonds. The higher the rating backed by a bond, the lower the risk. However, the greater the risk, the higher the expected return. The choice is up to the investor.
There are three major rating agencies around the world: Standard & Poor's, Moody's and Fitch. The highest rating that can be assigned to an issuer is AAA (the famous triple A). The further you go, the higher the risk.
Liquidity risk
Liquidity risk corresponds to the risk that an investor can take by holding one or more bonds, the volume of market transactions in which is small. In other words, if he decides to sell his bond, he will face liquidity risk if he does not find a counterparty willing to buy it back. The greater the trading volume of a bond, the lower the liquidity risk.
Interest risk
Interest rates are a measure of the value of a bond. They can increase or decrease and thus make bond investments more or less attractive compared to the coupon value.
If rates rise, the price of an already issued bond falls. Investors prefer to place at higher rates and therefore resell their existing bonds, which reduces their price. Thus, already issued bonds offer the same yield as the market one. Conversely, if rates fall, the value of the bond rises.
Schematically, when interest rates rise (for example, when major central banks raise their key rates), the price of outstanding bonds falls, and vice versa.
These changes have no effect on investors who hold their bonds to maturity, as they will be reimbursed for their original value. Savers simply incur losses if they hold on to the end of a bond that gave them a lower yield than other bonds issued later (in the event of a rate hike). If rates fall, they will forfeit their capital gains by keeping their bonds, but earn higher returns. The choice often depends on tax considerations. If income is taxed more than capital gains, capital gains will be favored, provided the difference is significant, as there may also be friction costs (entry fees for a new product you want to reinvest in).
In addition, the shorter the maturity of a bond, the lower the interest rate risk. Indeed, over a short time period, interest rate fluctuations will be less significant. Therefore, they will have less of an impact on the value of a bond that is approaching maturity.
Currency risk
Some bonds are denominated in different currencies. For example, if an investor owns US Treasury bonds, they are exposed to currency risk. Changes in the exchange rate can be both favorable and unfavorable for the investor.
Suppose an investor owns a US corporate bond priced at $100. At an EUR/USD exchange rate of 1.35, the price of the bond is 74.1 euros. If the exchange rate rises to 1.40, then the price of the bond will fall to 71.4 euros. A depreciation in the exchange rate results in a loss in the value of the bond. And vice versa, if an American investor has a French bond worth 100 euros, the growth of the dollar is beneficial for him.
Inflation risk
All savers and investors must face this risk. If inflation rises, the value and return on investment will inevitably fall. This is why some bonds are indexed to inflation. They guarantee their holders a daily adjustment of the value of their investments in accordance with the change in inflation.
How to limit risks on bonds?
Interest rate risk is the risk to which any saver or investor is exposed. It cannot be removed. On the other hand, all other risks can be reduced or even eliminated. For example, with regard to currency risk, for example, it is enough for a French investor to have bonds denominated in euros. Similarly, liquidity risk can be reduced by investing in securities with a high trading volume. Finally, investing in highly rated bonds significantly limits the risk of default. However, in the latter case, the output is also limited. It all depends on the risk the investor is willing to take.
