Bond Market Risks
Wednesday 26th June 2013
Some people consider bond investments, especially at the high quality end, to b...
Inflation Risk
Due to their relative safety, bonds tend not to offer extraordinarily high returns. That makes them
particu...
If a bond is downgraded this will dramatically affect the price.
The risk of default can be mitigated by investing in a bo...
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Bond Market Risks

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Some people consider bond investments, especially at the high quality end, to be risk free. This assumption is incorrect, as we have seen quite clearly in the past few weeks. They are potentially lower risk, for example if a company goes bust they will repay the bondholders before the shareholders, but they are not “no risk”. As a guide, I have listed the 3 main risks associated with bond investments below.

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Bond Market Risks

  1. 1. Bond Market Risks Wednesday 26th June 2013 Some people consider bond investments, especially at the high quality end, to be risk free. This assumption is incorrect, as we have seen quite clearly in the past few weeks. They are potentially lower risk, for example if a company goes bust they will repay the bondholders before the shareholders, but they are not “no risk”. As a guide, I have listed the 3 main risks associated with bond investments below. Interest Rate Risk This relates to the changes in market rates of interest, which have a direct effect on bond investments. The prices of fixed-income securities (bonds) generally move inversely to the direction of bank interest rates. So, when bank interest rates are rising, the market prices of bonds tend to fall, because new investors in those bonds will want a competitive yield (the bond's effective rate of interest). This is what has spooked bond markets in the past week; suggestions by Ben Bernanke that US interest rates will eventually rise. Likewise, when interest rates are falling, bond prices will rise. The longer the maturity of a bond, the greater the interest rate risk will be from the increased potential that over time interest rates will rise.
  2. 2. Inflation Risk Due to their relative safety, bonds tend not to offer extraordinarily high returns. That makes them particularly vulnerable when inflation rises. For example, if you bought a bond issued by the U.S. government, that’s about as safe an investment as you can find. As long as you hold the bond until maturity and the U.S. government doesn’t collapse, nothing can go wrong - unless inflation climbs. If the bond is paying a rate of interest of 3% for example, and the rate of inflation rises to, say, 4%, your investment will not “keep up with inflation.” In fact, you’d be “losing” money because the value of the cash you invested in the bond is declining. You’ll get your principal back when the bond matures, but it will be worth less in real terms. The Risk of Default This last risk is dependent upon the creditworthiness (the ability to make the scheduled interest payments and repay the principal when the bond matures) of the issuer of the security. Credit risk varies with bond issuers. U.S. Treasury issues carry virtually no risk of default because they're completely backed by the federal government. Bonds issued by state and local governments are slightly riskier and depend on the financial health of the particular issuer and its ability to raise revenue. Credit risks associated with corporate bonds are linked to the companies' balance sheets, income statements, and earnings capacities. Independent ratings services evaluate the credit risk of government and corporate bonds. These range from the best credit quality for issuers with the strongest financial status to the lowest ratings for issuers in default. Standard & Poor's is one of the best-known ratings agencies. Bonds with S&P ratings of AAA, AA, A, and BBB are considered to be investment-grade quality. Bonds with ratings below BBB are considered to be junk bonds and are speculative.
  3. 3. If a bond is downgraded this will dramatically affect the price. The risk of default can be mitigated by investing in a bond fund as opposed to investing in bonds from one specific issuer. By investing in fund you spread your risk over a number of issuers so that if one of them defaults then you don’t lose your shirt. Other posts you might find interesting: 1. An Introduction to ETFs 2. Top Expat Financial Planning Mistakes #1 - Currency Mismatch 3. Seven Ways to Spot a Boiler Room Scam [If you found this post useful, feel free to sign up for my regular monthly newsletter which is full of handy financial planning tips for expatriates. Just enter your contact details here.] Image Credits: Image courtesy of renjith krishnan / freedigitalphotos.net Image courtesy of Kittisak / freedigitalphotos.net Image courtesy of chrisroll / freedigitalphotos.net

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