In this article, Rodolphe Chollat-Namy (ESSEC Business School, Master in Management, 2019-2023) introduces you to bond risks.
Holding bonds exposes you to fluctuations in its price, both up and down. Nevertheless, bonds offer the guarantee of a coupon regularly paid during for a fixed period. Investing in bonds has long been considered one of the safest investments, especially if the securities are held to maturity. Nevertheless, a number of risks exist. What are these risks? How are they defined?
Default risk is the risk that a company, local authority or government fails to pay the coupons or repay the face value of the bonds they issued. This risk can be low, moderate or high. It depends on the quality of the issuer.
For a given product, the default risk is mainly measured by rating agencies. Three agencies share 95% of the world’s rating requests. Moody’s and Standard & Poor’s (S&P) each hold 40% of the market, and Fitch Ratings 14%. The highest rated bonds (from Aaa to Baa3 at Moody’s and from AAA to BBB- at S&P and Fitch) are investment-grade bonds. The lowest rated bonds (Ba1 to Caa3 at Moody’s and BB+ to D at S&P and Fitch) are high yield bonds, otherwise known as junk bonds.
It should be noted that the opinions produced by an agency are advisory and indicative. Moreover, some criticisms have emerged. As agencies rate their clients, questions may be asked about their independence and therefore their impartiality. The analysis done aby rating agencies is most of the time paid by the entities that want their product to be rated.
In addition, companies issuing bonds are increasingly using the technique of “debt subordination”. This technique makes it possible to establish an order of priority between the different types of bonds issued by the same company, in the event that the company is unable to honor all its financial commitments. The order of priority is senior, mezzanine and junior debt. The higher the risk is, the higher the return is. It should also be noted that bonds have priority over equity.
To highlight the level of risk of an issuer, one can compare the yield of its bonds to those of a risk-free issuer. This is called the spread. Theoretically, it is the difference between the yield to maturity of a given bond and that of a zero-coupon bond with similar characteristics. The spread is usually measured in basis points (0.01%).
Liquidity risk is the degree of easiness in being able to buy or sell bonds in the secondary market quickly and at the desired price (i.e. with a limited price impact). If the market is illiquid, a bondholder who wishes to sell will have to agree to a substantial discount on the expected price in the best case, and will not be able to sell the bonds at all in the worst case.
The risk depends on the size of the issuance and the existence and functioning of the secondary market for the security. The liquidity of the secondary market varies from one currency to another and changes over time. In addition, a rating downgrade may affect the marketability of a security.
On the other hand, it may be an opportunity for investors who want to keep their illiquid bonds. Indeed, they usually get a better return. This is called the “liquidity premium”. It rewards the risk inherent in the investment and the unavailability of funds during this period.
Interest rate risk
The price of a bond fluctuates with interest rates. The price of a bond is inversely correlated to interest rates (the discount rate used to compute its present value). Indeed, the nominal interest rates follow the key rates. Thus, if rates rise, the coupons offered by new bonds will be higher than those offered by older bonds, issued with lower rates. Investors will therefore prefer the new bonds, which offer a better return, which will automatically lower the price of the older ones.
The interest rate risk is increasing with the maturity of the bond (more precisely its duration). The risk is low for bonds with a life of less than 3 years, moderate for bonds with a life of 3 to 5 years and high for bonds with a life of more than 5 years. However, interest rate risk does not impact investors who hold their bonds to maturity.
Inflation presents a double risk to bondholders. Firstly, if inflation rises, the value of an investment in bonds will necessarily fall. For example, if an investor purchases a 5% fixed-rate bond, and inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. Secondly, high inflation can lead central banks to raise rates in order to tackle it, which, as we can see above, will depreciate the value of the bond.
To protect against this, some bonds, floating-rates bonds, are indexed to inflation. They guarantee their holders a daily readjustment of the value of their investment according to the evolution of inflation. However, these bonds have a cost in terms of return.
As with interest rate risk, the risk increases with the maturity of the bond. Also, the risk rises as the coupon decreases. The risk is therefore very high for zero-coupon bonds.
An investor can buy bonds in a currency other than its own. However, as with any investment in a foreign currency, the return on the bond will depend on the rate of that currency relative to the investor’s own currency.
For example, if an investor holds a $100 US bond. If the EUR/USD exchange rate is 1.30, the price of the bond will be €76.9. If the euro appreciates against the dollar and the exchange rate rises to 1.40, the price of the bond will be €71.4. Thus, the investor will lose money.
About the author
Article written in May 2021 by Rodolphe Chollat-Namy (ESSEC Business School, Master in Management, 2019-2023).