Risks of investing in Bonds

Warning: The following is a list of some of the important risks factors that prospective investors should consider prior to making a decision to invest in Bonds. The list is not intended to be comprehensive or exhaustive. Various other risks also apply, depending on the bond acquired. You should ensure that you fully understand the risks associated with any investment prior to making a decision to invest. You should also consult Davy Select in the event that you require further information or have any queries in relation to same.

The Relationship between Risk and Return

Risk is an inherent part of investing. Generally, investors must take greater risks to achieve greater returns, however taking on additional risk does not always lead to greater returns. Investors who take on additional risk, must be comfortable with experiencing significant periods of underperformance in the expectation of achieving higher returns over the longer term. Those who do not bear risk very well have a relatively smaller chance of making high earnings than do those with a higher tolerance for risk; similarly they have a smaller chance of making significant losses. It's crucial to understand that there is an inevitable trade off between investment performance and risk. Higher returns are associated with higher risks of price fluctuations.


It is important to establish your attitude to risk before you begin investing.  Is the security of your capital the overriding influence in your investment decisions or are you willing to  tolerate the ups and downs of the market in the expectation of higher returns?


Although not always the case, generally speaking, the level of return on your investments will reflect the underlying risk. If you’re only willing to accept low or zero levels of uncertainty, your investment returns are also likely to be low. However, an investment that seems very attractive in terms of its potential return may not be the right choice if it carries an unacceptably high risk. High risk investments generally require that the investor has the ability to hold it for the longer term (5-10 years), in order to allow shorter term performance issues time to resolve themselves. Importantly, investors should remember however that accepting high levels of risk does not always result in high returns.


Not all investment decisions will turn out as expected, but diversification can be a key tool in managing risk. By acquiring a portfolio of varied investments across a range of asset classes (shares, bonds, cash, etc), geographies and sectors, investors can minimise the effects which poorly performing investments can have on their overall portfolio. This diversification theory applies within asset classes as much as at portfolio level.


There are specific risks which investors should be aware of when investing in certain asset classes. The following sections deal with some of the risks which apply when investing in bonds.

 

The main risks of investing in bonds include the following:

Interest Rate Risk


Rising interest rates are a key risk for bond investors. Generally, rising interest rates will result in falling bond prices, reflecting the ability of investors to obtain an attractive rate of interest on their money elsewhere. Remember, lower bond prices mean higher yields or returns available on bonds. Conversely, falling interest rates will result in rising bond prices, and falling yields. Before investing in bonds, you should assess a bond’s duration (short, medium or long term) in conjunction with the outlook for interest rates, in order to ensure that you are comfortable with the potential price volatility of the bond resulting from interest rate fluctuations.


Credit Risk


This is the risk that an issuer will be unable to make interest or principal payments when they are due, and therefore default. Rating agencies such as Moody’s, Standard & Poors (S&P) and Fitch assess the credit worthiness of issuers and assign a credit rating based on their ability to repay its obligations. Fixed income investors examine the ratings of an issuer in order to establish the credit risk of a bond. Ratings range from AAA to D. Bonds with a ratings at or near AAA are considered very likely to be repaid, while bonds with a rating of D are considered to be more likely to default, and thus are considered more speculative and subject to more price volatility.


Inflation Risk


Inflation reduces the purchasing power of a bond’s future coupons and principal. As bonds tend not to offer extraordinarily high returns, they are particularly vulnerable when inflation rises. Inflation may lead to higher interest rates which is negative for bond prices. Inflation Linked Bonds are structured to protect investors from the risk of inflation. The coupon stream and the principal (or nominal) increase in line with the rate of inflation and therefore, investors are protected from the threat of inflation.


Reinvestment Risk


When interest rates are declining, investors may have to reinvest their coupon income and their principal at maturity at lower prevailing rates.


Liquidity Risk


This is the risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value. To minimise this risk, investors may wish to opt for bonds that are part of a large issue size and also most recently issued. Bonds tend to be most liquid in the period immediately after issue. Liquidity risk is usually lower for government bonds than for corporate bonds. This is because of the extremely large issue sizes of most government bonds. However the sovereign debt crisis has resulted in a decline in the liquidity of government bonds issued by smaller European peripheral nations.


These are just some of the risks that are associated with an investment in bonds. Individual bonds will have their own individual risks. It is critical that investors understand the effect that these risks can have on their investments. Further information is available from Davy Select on request.