Various kind of risks that Bonds have

Risk means Uncertainty or a situation that involves an exposure to danger. It is pervasive and
is inevitable. Every investment that investors do should be viewed in terms of risk and return.

Bonds are subjected to diverse risks, such as credit risk, interest rate risk, inflation risk, real
interest rate risk, sovereign risk, default risk, call risk, liquidity risk, and reinvestment risk.

1. Credit Risk:

 Credit risk is the risk of failing in the payment of interest and principal amount.
 The rating agencies such as Moody, S&P, Cure Rating assess the credit worthiness of
issuers and assign a credit rating based on their ability to repay its obligation,
 Lower rated bonds have extra yield called credit speed. Credit speed is the excess
yield offered by a security relative to a less risk security with the same maturity and
almost similar liquidity.
 Credit risk and hence credit speed are inversely related to the issuer rating. Lower the
credit rating, higher will be the credit risk and higher will be credit speed.

2. Sovereign Risk:

 Any risk that arises on the occasion when a government fails to make debt repayment.
 It can be viewed as credit risk of government securities in foreign nation.
 When an investor holds a bond issued by a foreign entity, they may be exposed to
default risk or an unfavorable price change.
 Sovereign risk is generally low, but it can cause losses for the investor in bond if the
issuer nation economy is experiencing economic waves.

3. Exchange Rate Risk:

 The exchange rate risk is caused by fluctuation in the investors local currency to the
foreign investment currency.
 Investor holding bonds that are issued abroad and denominated in foreign currency
face this kind of risk.

4. Liquidity Risk:
  Liquidity risk is the risk that occurs for investors when they are unable to find a buyer
for a bond that they need to sell.
 Most debt instruments are known to have a low liquidity market. Investors face
difficulty in trading debt instruments, especially when the quantity of debt instruments
is more.
 Hence, the investors will have to accept a discounted rate over the quoted price on
selling and pay premium while buying. Thus selling the security at a price lower than
the market value.
 Liquidity risk is generally lower for government bonds than corporate bonds.
 Investors prefer to have more liquidity for their securities. A less liquidity for
securities will decrease the price of bond and increase the bond yield.
 To minimize the risk of liquidity, investors wish to opt for bonds that are issued in
large sizes and are recently issued.

5. Interest Rate Risk:

 Interest Rate Risk is a risk that arises for bond holder due to fluctuating interest rate.
The interest rate on a bond depends on the sensitivity of the bond to the changes in
interest rate in the market.
 Rising interest rate are a key risk for bond investors. Bond price and interest rates are
inversely correlated.
 Generally rising rate will result in falling of bond price because the opportunity cost
of holding those bonds increases. Thus, the cost of missing out on an even better
investment is greater.
 When a bond is issued, it is given a coupon rate which is equal to the interest rate
currently in the market. After the bond is issued, the market interest rate may change
but the interest rate on the bond will remain the same until maturity. Thus, the change
in the market interest rate relative to the coupon rate casus changes in the market price
of the bond.
 Thus, when the market rate increases than the coupon rate, the market price of the
bond will decrease and vice versa.
 Interest rate risk is good for the issuer but bad for the investor.

6. Inflation Risk:
  Inflation occurs when the cost-of-living increases. During inflation times, the interest
rates are defined in nominal terms, where nominal rate = real rate + inflation rate.
 When there is increase in inflation rates, government makes effort to reduce the
inflation by increasing the interest rates.
 Since bond interest payment are fixed, their value can be eroded by inflation. Increase
in inflation decreases the purchasing power of interest payment that a bond makes.
 Inflation has negative impact on fixed income securities. As inflation rises, central
bank will increase the interest rate in effort to cool down the economy. The rise in
interest rate will lower the bond price.
 When investors worry that the bond yields will not be able to cope with rising rate of
inflation, the investment will be less and the demand for the bond will decrease and
hence the price of the bond will also decrease.

7. Call Risk:

 A bond may have a call option that gives the issuer an option to redeem the bond
before maturity but after a specific period.
 When the interest rate falls, the issuer calls back the bond and re-issues the bond at
lower interest rate which is beneficial to the firm but not to the investor or holder.
 In such case the investors have no option but to accept a lower rate of interest.
 Bonds that are not callable have no call risk.

8. Re-investment Risk:

 Bond pays the periodic interest rate, but there is a risk that these interest payments
have to be re-invested in the lower rate. Such risks are called periodic risks or re-
investment risks.
 Re-investment risks are higher for the bonds with longer maturity and for bonds with
higher interest payments.

9. Volatility Risk:

 Bonds that come with embedded options such as call option, put option, etc. are
subject to face volatility risk.
 When there is a change in interest rate, the value of the bonds fluctuates.

10. Real Interest Rate Risk:

  In conditions where there is no inflation risk, investors and issuers are still exposed to
the risk of fluctuations in the real interest rate.
 Due to postponement of consumption, real interest rate will be affected. When there is
change in supply and demand of funds, real interest rate fluctuates.
 For example, if the real interest rate has fallen from 8% - 5%, the firm that suffers real
interest rate risk change will pay 8% while investing and get a return on investment of
5%.
 Thus, fluctuations in real interest rate indicate the risk the investors and issuers have
to face while buying and selling bonds.

11. Default Risk:

 The risk that the investor or borrower might not pay interest and/or principal amount
on time is called default risk.
 It is unlikely that bonds have an actual default risk. However, changes in the
perceived default risk of a bond would have an impact on the market of price of the
bond
 Such bonds are sold at lower prices that government securities and generate higher
bond yield on maturity.