What are fixed-income risks?
Fixed income risks occur based on the volatility of the environment. Risks will impact the market value of the security when it is sold, cash flow from the security, and additional income made by reinvesting cash flows. By understanding the risks involved, investors can be more informed as to the type of fixed income security to purchase.
Quick Summary Points
- Fixed income risks occur due to the unpredictability of the environment
- 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, sector risk
Breaking down the risks
The 11 risks associated with fixed income securities are:
- Interest rate risk
- Reinvestment risk
- Call/prepayment risk
- Credit risk
- Inflation risk
- Liquidity risk
- Exchange rate risk
- Volatility risk
- Political or legal risk
- Event risk
- Sector risk
Interest rate risk
The two types of interest rate risks are the level risk and yield curve risk. Both have a negative effect on the value of a bond. This is due to the nature of a bond. As the interest rate increases, the value of the bond decreases. This is known as the inverse relationship between bond value and interest rate.
Reinvestment risk arises when reinvesting the income received from securities. It is similar to interest rate risk as it is the change in the interest rate that makes profits volatile. However, for reinvestment risk, it is beneficial if the interest rate increases. When reinvesting proceeds from investments, it is beneficial to have a high-interest rate as a person will get better 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 for purchasing a bond with a provision like this. Firstly, there is uncertainty with the cash flow of the bond because an expected five-year cash flow might end early. Secondly, 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 which are unfavorable in a low-interest rate environment. Lastly, 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 and 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 was 8%, the coupon will have relatively less value. Since the interest rate or coupon rate of the securities are fixed, they are heavily influenced by inflation rates.
The liquidity risk is the risk a bond owner has to sell a bond below its true value. Liquidity can be defined as the size of the spread before the ask price and the bid price. The ask price is the minimum price a seller is willing to sell a security 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 risk is the risk that cash flows from securities lose value after exchanging it to a different currency. For example, if an investor has an international bond that pays in pounds, the investor would only know the cash flow in dollars at the time of the cash flow. 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. 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 demonstrates 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 was not directly impacted, through the spillover effect, they were negatively impacted.
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 will allow 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 as some sectors might offer better yields.
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