The Finance Tutor

Return to Homepage

Common Bond Risks

The following are the most common risks associated with bonds and other fixed income securities:

Interest Rate Risk

Interest rate risk is one of the most significant risks associated with fixed income investing because changes in market interest rates can have dramatic effects on the value of outstanding bonds. You may have heard the expression, “bond prices move inversely to interest rates.” Reference the tutorial: Interest Rate Risk: A Comprehensive Analysis for a complete review of interest rate risk and interest rate volatility.

Credit Risk

Credit Risk is the risk that the issuer of a bond could experience financial strains and become unable to make interest and/or principal payments. Independent credit rating agencies such as Moody's and Standard and Poor's monitor the financial soundness of many companies and municipalities and publish ratings that reflect their financial conditions. Reference the tutorial, Credit Risk: Comprehensive Analysis for a complete overview.

Reinvestment Risk

Reinvestment risk is the risk that interest rates could fall below the level that existed when a bond was originally purchased. In this situation, an investor will have to reinvest the bond’s coupon payments in new securities that yield lower rates of return. Bond’s with higher coupon rates have greater reinvestment risk. Bond’s with longer maturities are also more vulnerable to reinvestment risk.

Inflation Risk

Inflation Risk is the risk that inflation will deteriorate the purchasing power of coupon income. An investment’s nominal return less inflation equals its real rate of return. For example, a bond may provide an annual, nominal rate of return of 7.0%. However, if inflation is 3.1% during the annual period, the real rate of return will equate to 3.9%.

Call Risk

If low interest rates entice a bond issuer to execute a call option, the investor will be left with a less desirable market (ie: lower yields and higher bond prices) to reinvest the proceeds. Reference the tutorial, Bonds with Embedded Call Options, for a review.

Circumstance Risk

Circumstance risk, also known as event risk, is the risk of an unpredictable catastrophe that could adversely impact the bond markets. Natural disasters, adverse political actions, and acts of terrorism are all examples of events that create circumstance risk.

Industry/Sector Risk

Industry/Sector Risk is the risk that an industry will experience a downturn that could adversely affect the financial condition of its participants and their ability to meet debt service requirements. A classic example is the airline sector which suffers tremendously when oil and gas prices rise.

Liquidity Risk

Liquidity Risk is the risk that a holder may be unable to sell a bond quickly when needed. If a bond is traded thinly in the market an investor may have to apply a substantial discount to the price to attract a bidder. A bond’s market spread is a good measure of its liquidity. A large spread generally indicates that a bond is thinly traded and may have a degree of liquidity risk, while a small spread generally indicates that a bond is highly traded, liquid, and less vulnerable to liquidity risk.