Risks

There are many risks that bonds are subject to. We will discuss two categories of bond risks: systematic and non-systematic.

Systematic risks

As a reminder, systematic risks negatively affect a large portion or the entire market. There are two systematic risks to know for bonds: interest rate risk and inflation (purchasing power) risk.

Earlier in this chapter, we discussed price volatility, which relates to interest rate risk. We learned that bonds with long maturities and low coupons tend to move the furthest in price when things change in the market. Bond prices are most commonly influenced by interest rate changes.

Interest rate risk, sometimes referred to as market risk for bonds, is the risk that interest rates rise, which forces market prices of bonds down. As a reminder, market prices fall to make older bonds more marketable than newer bonds being issued at higher rates of interest. Interest rate risk applies to all fixed-income investments, which also include preferred stock.

While most bonds have a fixed interest rate, variable rate bonds do exist (we’ll learn about some of the specifics in future sections). These securities have coupons that adjust periodically (usually on a monthly or semi-annual basis) to interest rate changes, keeping their market values stable. Therefore, variable rate securities avoid interest rate risk.

We discussed inflation (purchasing power) risk in the preferred stock chapter, which occurs if higher levels of inflation reduce the value of an investment. Bonds are particularly susceptible to purchasing power risk due to their fixed coupons. Investors receive a fixed amount of interest over the life of the security. If prices of everything from milk to cars to real estate rise, the fixed amount of interest now has less purchasing power (buys less).

When you prepared for the SIE exam, you learned how the Federal Reserve influences interest rates to manage the economy. When inflation rises, the Fed raises interest rates to drive down general economic demand (borrowing money is more expensive), typically resulting in prices of goods and services stabilizing. Purchasing power and interest rate risk are very closely tied together for this reason. When interest rates rise, bond market prices fall.

Just like interest rate risk, the longer the maturity of a bond, the more purchasing power risk a bond has. To avoid the risks of inflation, investors should seek short-term bonds. By doing so, they’ll be able to reinvest their proceeds into bonds with higher rates of interest when the bond matures instead of being stuck with a lower interest rate for a long period of time.

Non-systematic risks

Non-systematic risks negatively affect specific securities, not the entire market. There are several types of non-systematic bond risks to be aware of.

Default risk, sometimes referred to as credit risk, occurs when an issuer is unable to make required interest and/or principal payments to investors. The typical reason for default risk is bankruptcy.

Bankruptcy isn’t very common, but it does happen. Corporations and even governments default on their debts (although government defaults are rare). For example, the city of Detroit declared bankruptcy and defaulted on its bonds in 2013. It was (and still is) the largest default by a municipal (local government) issuer in the history of the United States. If you held a Detroit bond at the time, you probably ended up losing a substantial amount of money due to their bankruptcy.

Rating agencies help investors determine the default risk of specific bonds. Standard & Poors (S&P), Moody’s, and Fitch are the three rating agencies to know for the exam. While their ratings look slightly different, they all rate bonds based on their default risk. Here’s how their ratings appear:

It’s important to know the difference between investment grade and speculative bonds. Investment grade bonds have little to no default risk. Investment grade bonds have ratings of BBB (Baa for Moody’s) or higher.

Speculative bonds, sometimes referred to as junk bonds, are subject to considerable default risk. The lower the rating, the more default risk. Speculative grade bonds have ratings of BB (Ba for Moody’s) or lower.

Liquidity risk, sometimes referred to as marketability risk, occurs when a security cannot be sold or requires a deep discount to be sold. Certain investments come with higher levels of liquidity risk. For example, municipal bonds are notorious for their liquidity risk. We’ll discuss why in a future chapter.

Generally speaking, the less desirable a bond, the more liquidity risk it has. Simply put, if investors don’t like what a bond has to offer, it might be tough to sell it. If you owned a bond from a company on the brink of bankruptcy, you may not be able to sell the bond without a drastic discount in price (or maybe not at all).

Legislative risk occurs when a law or regulation (usually domestic) negatively affects an investment. For example, the tariffs imposed by the Trump administration in 2018 increased the cost of doing business with foreign companies from certain countries. Investors holding securities involved with international trade experienced legislative risk when the financial markets responded negatively to the trade war.

Political risk occurs when there’s instability or a sudden change in government. For example, assume you own a Ukrainian bond. If an unexpected military coup completely replaces Ukraine’s old government, it’s very possible that your bond will default. Unless the new government plans on paying off the old government’s debts, it’s likely you would lose a significant amount of money.

While political instability could happen anywhere, it’s generally viewed as a foreign risk. The United States has its political disagreements, but we have a relatively stable political structure in place.

Reinvestment risk occurs when interest rates fall. While it could be argued that reinvestment risk is more of a systematic risk, this risk applies most to bonds with high coupons, frequent interest payments, and callable bonds.

Although bond prices rise when interest rates fall, reinvestment risk focuses on money reinvested back into the market. Long-term investors typically keep their money invested at all times. When an investment pays dividends or interest, that money could be used to purchase a new security (or buy more of the same security). When interest rates fall, bond investors reinvest their money into bonds with lower rates of return.

Bonds with the highest and most frequent interest payments have the most reinvestment risk. In the US Government bond chapter, you’ll learn about mortgage-backed securities, which make monthly payments to their investors. They have high levels of reinvestment risk due to the frequency of their payments. The more cash to reinvest, the more reinvestment risk. To the contrary, zero coupon bonds are considered to have no reinvestment risk. When a bond doesn’t pay ongoing interest, there’s nothing to reinvest!

Earlier in this chapter, we reviewed callable bonds. Call risk, which occurs when a callable bond is likely to be called (or actually is called), is a type of reinvestment risk. Bonds are most likely called when interest rates fall, which allows issuers to reissue new bonds at lower interest rates (refinancing).

Call risk is the worst form of reinvestment risk. Instead of just reinvesting interest received at lower rates of return, the investor must reinvest interest plus the principal they receive when the bond is called. Because the investor is reinvesting a larger amount of capital, call risk is a very substantial risk.