Risks Inherent in Bonds

What is credit risk?

Arguably, the most significant bond risk is credit risk. Bonds are, essentially, securities which represent the issuer borrowing money. Whenever money is borrowed there is an expectation that it will be paid back, with interest, but there is a chance that the borrower will fail to do this – that they will default on their obligations by not fulfilling them.

Creditors may perform a credit analysis where they analyse the borrower through:

• Its character - what it is like as a company or as a national government
• Its capacity to take on debt
• Its cash flow generation to service that debt
• Any protections or covenants that the borrower may provide to the investor
• Any collateral or security that is provided to protect the investor in the event of default

The best credits, with the lowest probability of default, are rated “Triple A”. As you go down the credit spectrum you move down through investment grade into sub-investment grade or “high yield” bonds. These credit ratings are relied on a huge amount by investors and many others throughout the bond industry.

What are credit spreads?

The spread is the amount of extra yield that the investor receives over and above the Treasury bond yield and compensates the investor for taking the added default risk.

Note that, for all except the high yield bonds, the spreads get larger with maturity.

What is credit spread risk?

There is another, closely related, risk that the investors also bears – and that is credit spread risk. If the credit spread on the bond changes after the bond has been bought, then the price that the bond can be sold at will change and the portfolio will have made or lost money.

What is liquidity risk?

Whilst US treasury bonds are very liquid and positions in these can easily be traded in and out of in large size, liquidity on other bond issues is often not so good, especially as we go down the credit spectrum. When buying a less liquid bond, an investor is not so certain they will be able to easily turn their bond position immediately back into cash. It is for this reason that people say bonds have greater “liquidity risk” and that the spread, as well as compensating for the risk of default, also includes a liquidity premium – which is the extra spread that is paid to the investor for taking the risk of illiquidity- that they will not be readily able to sell their bonds.

What are some other risks?

We have seen the main categories of risk borne by bond investors – interest rate risk, credit default risk, credit spread risk, liquidity risk.

But there are a whole host of other potential risks:

• Bonds may have explicit inflation risk from having inflation-linked cash flows
• They may have options to redeem early and so have the risks associated with that optionality such as volatility risk
• They have currency risk if they are in a different currency to the investors base currency
• There is funding risk if money is borrowed to buy the bond