Risks arising from the volatility of the bond market environment
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Fixed income risks occur based on the volatility of the bond market environment. Risks impact the market value of the security when it is sold, cash flow from the security while it is held, and additional income made by reinvesting cash flows. By understanding the risks involved, investors can be more informed as to the best fixed income security to purchase.
Fixed income risks occur due to the unpredictability of the market.
Risks can impact the market value and cash flows from the security.
The major risks include interest rate, reinvestment, call/prepayment, credit, inflation, liquidity, exchange rate, volatility, political, event, and sector risks.
Breaking Down the Risks
The 11 risks associated with fixed income securities are:
The two types of interest rate risk are the level risk and yield curve risk. Both have a potentially negative effect on the value of a bond. As interest rates increase, the value/price of the bond decreases. This is known as the inverse relationship between bond value and interest rates.
Reinvestment risk arises when reinvesting the income received from securities. To reduce reinvestment risk, it is beneficial if interest rates increase. When reinvesting proceeds from investments, it is beneficial to have a higher interest rate, as the investor will then obtain higher returns. Therefore, reinvestment risk is the risk that interest rates will decrease.
This type of risk arises when the issuer of a bond has a right to “call” the bond. This means the issuer can take back the bond before the maturity date. There are three main disadvantages for investors in purchasing a bond with a provision like this.
First, there is uncertainty with the cash flow of the bond because an expected five-year cash flow might end early. Second, if the bond is called when the interest rate is low, then the investor is subject to reinvestment risk.
Since the investor will receive payment for the bond that is called, they will likely reinvest the proceeds, a practice which is unfavorable in a low interest rate environment. Finally, the appreciation of bond price will not exceed the price at which the issuer may call the bond.
Credit risk includes default risk and inferior performance. Default risk is the possibility that the issuer will not pay the principal or coupon for the bond. The risk of inferior performance depends on the performance of other, similar bonds.
Inflation or purchasing power risk is the risk that the cash flow from securities will lose value due to inflation. For example, if the coupon rate for a bond is 5% but the inflation rate is 8%, then the coupon will have relatively less value. Since the interest rate or coupon rate of the securities is fixed, they are heavily influenced by inflation rates.
The liquidity risk is the risk that a bond owner may have to sell a bond below its true value. Liquidity can be defined as the size of the spread between the ask price and the bid price. The ask price is the minimum price a seller is willing to sell a security for, while the bid price is the maximum price a buyer is willing to spend on a security. The higher the spread between the bid and ask price, the lower the liquidity and the higher the liquidity risk.
Exchange rate risk
Exchange rate risk is the risk that cash flows from securities lose value after exchanging them for a different currency. For example, if an investor has an international bond that pays in British pounds, the investor would only know the cash flow in dollars.
This is because the exchange risk is constantly changing. If the pound depreciates against the U.S. dollar, then fewer dollars will be received. On the other hand, if the pound appreciates against the dollar, then the investor will receive more dollars.
The volatility risk is the risk that a security will lose value due to a change in volatility. This occurs when a bond is embedded with an option. As volatility increases, the value of the option increases as well. In the case of a callable bond, as the value of a call option increases, the value of the bond decreases. So, the bond is exposed to volatility risk.
Political or legal risk
Political or legal risk arises when actions by the government adversely affect the value of a security. For example, the government can either change the tax rate or declare a bond as taxable when it was previously tax-free. If an investor has a tax-exempt bond, then the bond will be more valuable if the tax rate is high, as people will have more incentive to have a tax-exempt investment.
However, if the government lowers the tax rate, then the tax-exempt bond will lose value. Also, if the government announces the bond is no longer tax exempt, then the bond’s value will decline as well.
An event risk refers to an unexpected event that decreases the value of a bond. The two types of event risks are a natural or industrial accident, or corporate restructuring. An example of a natural event is the tsunami that hit Japan in 2011 that damaged a nuclear reaction plant. Even though other utility companies using nuclear power were not directly impacted, they were negatively impacted through the spillover effect.
This is the risk that an event that occurs within a sector will adversely affect the value of bonds. For example, if there was an exceptionally big forest fire, the forestry sector will be adversely impacted. This type of risk is different for each sector and the amount of exposure depends on the sector.
Why risks matter
Understanding fixed income risks enables investors to understand the exposures they are taking on by investing in corporate, government, or international bonds. It also allows investors to decide the type of risk they are willing to take on. For example, some investors might be willing to take on sector risk if the sector offers substantially higher yields.
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