Liquidity risk in bonds

Investors in bonds also face liquidity risk. This is the risk that the investor may
have to sell the bond at a price lower than the expected price. Based on the
market conditions and also on a review of recent market transactions, the
investor can get an idea of the indicative price at which he will be able to sell
his security. But when he approaches a dealer/broker and gets a lower rate than
what he expects, it’s due to lower liquidity in the particular instrument.

Let’s review some important points about liquidity risk in bonds:

 Liquidity risk is measured using the bid ask spread. Bid price is he price
at which a dealer will buy the security from the investor, and ask price is
the price at which the dealer will sell the security to the investor. For
instruments having high levels of liquidity, the bid-ask spread will be
very small and will not be affected by the size of the transaction.
However, as liquidity deteriorates, the bid-ask spread widens.
 Since it’s a dealers market and every dealer offers its own bid-ask quote,
different people may interpret liquidity differently. A good way is to
compare quotes from different dealers and select the best bid price
(lowest) and best ask price (highest). This is referred to as the market bid-
ask spread.
 For investors holding the bond till maturity but not marking their position
to market, liquidity risk is not very important.
 For investors who are required to mark their position to market (such as
mutual funds), liquidity risk is of concern, as the bid price will change.
To mark a position to market the investor may take quotes from many
dealers and then use the best bid price as the new price for the position.
 For instruments that are very illiquid, the investor may not be able to rely
on a quote from the dealer. Instead he will use models to estimate the fair
value of the instrument.
 As market conditions change, bid-ask spread may change over time.
Changing market conditions may also change impact liquidity and widen
bid-ask spread as investors wait before taking new positions.
 The market for new products may be less liquid initially but the liquidity
may improve as more brokers/dealers take interest in these products.
Rating Downgrades of Bonds

A company's ability to operate and repay its debt issues is frequently

evaluated by major ratings institutions such as Standard and poor rating
service or Moody’s rating agency. Ratings range from AAA for
high credit quality investments to D for bonds in default.1
 The decisions made and judgments passed by these agencies carry a lot
of weight with investors.
 If an issuer's corporate credit rating is low or its ability to operate and
repay is questioned, banks and lending institutions will take notice and
may charge a higher interest rate for future loans. This can adversely
impact the company's ability to satisfy its debts and hurt existing
bondholders who might have been looking to unload their positions.

Credit Risk of bonds

Credit risk is the possibility of a loss resulting from a borrower's failure to repay
a loan or meet contractual obligations. Traditionally, it refers to the risk that a
lender may not receive the owed principal and interest, which results in an
interruption of cash flows and increased costs for collection. Excess cash
flows may be written to provide additional cover for credit risk. When a lender
faces heightened credit risk, it can be mitigated via a higher coupon rate, which
provides for greater cash flows.

Although it's impossible to know exactly who will default on obligations,

properly assessing and managing credit risk can lessen the severity of a loss.
Interest payments from the borrower or issuer of a debt obligation are a lender's
or investor's reward for assuming credit risk.

Understanding Credit Risk

When lenders offer mortgages, credit cards, or other types of loans, there is a
risk that the borrower may not repay the loan. Similarly, if a company offers
credit to a customer, there is a risk that the customer may not pay their invoices.
Credit risk also describes the risk that a bond issuer may fail to make payment
when requested or that an insurance company will be unable to pay a claim.

Credit risks are calculated based on the borrower's overall ability to repay a loan
according to its original terms. To assess credit risk on a consumer loan, lenders
look at the five c’s: credit history, capacity to repay, capital, the loan's
conditions, and associated collateral.1
Some companies have established departments solely responsible for assessing
the credit risks of their current and potential customers. Technology has
afforded businesses the ability to quickly analyze data used to assess a
customer's risk profile.

If an investor considers buying a bond, they will often review the credit rating
of the bond. If it has a low rating (< BBB), the issuer has a relatively high risk
of default. Conversely, if it has a stronger rating (BBB, A, AA, or AAA), the
risk of default is progressively diminished.

Bond credit-rating agencies, such as Moody's Investors Services and Fitch

Ratings, evaluate the credit risks of thousands of corporate bond issuers and
municipalities on an ongoing basis. For example, a risk-averse investor may opt
to buy an AAA-rated municipal bond. In contrast, a risk-seeking investor may
buy a bond with a lower rating in exchange for potentially higher returns.

Credit Risk vs. Interest Rates

 
If there is a higher level of perceived credit risk, investors and lenders usually
demand a higher rate of interest for their capital.

Creditors may also choose to forgo the investment or loan.

For example, because a mortgage applicant with a superior credit rating and
steady income is likely to be perceived as a low credit risk, they will receive a
low-interest rate on their mortgage. In contrast, if an applicant has a poor credit
history, they may have to work with a subprime lender—a mortgage lender that
offers loans with relatively high-interest rates to high-risk borrowers—to obtain
financing. The best way for a high-risk borrower to acquire lower interest rates
is to improve their credit score; those struggling to do so might want to consider
working with one of the best credit repair companies.

Similarly, bond issuers with less-than-perfect ratings offer higher interest rates
than bond issuers with perfect credit ratings. The issuers with lower credit
ratings use high returns to entice investors to assume the risk associated with
their offerings.