The risks that involved in investing in bonds are commonly split into five categories:
- Credit Risk.
- Interest Rate Risk.
- Inflation Risk.
- Call Risk.
- Reinvestment Risk.
Credit or Default Risk
This is the risk that the bond issuer will not be able to fulfill his financial responsibilities regarding the bond. An issuer that does not make interest or principal payments is said to default on the bond.
Interest Rate Risk
Interest rate risk stems from changes in the interest rate available in the market. When the interest rate rises, the vale of existing bonds falls. When the interest rate falls, the bonds’ prices go up. The longer away the maturity date of a bond is, the more sensitive their price will be to interest rate changes. A full explanation of this topic appears in the “Fundamentals of Bonds” course.
Inflation is the loss of purchasing power. The risk is that if there is inflation, the income generated by the bond will be worth less than projected. The more inflation there is, the more bond prices will be affected, particularly if they have a fixed interest rate. One way to neutralize inflation risk is to buy bonds that are linked to the CPI, so that their face value and interest payments are constantly adjusted for inflation.
Call or Prepayment Risk
Call risk only exists for callable bonds. In such a case, the investor is exposed to the possibility that he will need to part with the bond at a point in time when he wanted to hold it. Generally, issuers will want to call bonds when interest rates fall. In such a case, the issuers can than reissue the bonds at lower rates, and thereby save money. On the other hand, the investor now needs to find a different investment, and since the interest rate has fallen, he will have to settle for an alternative with a lower expected yield.
When a bond matures, the bondholder will need to find a new investment. There is always the risk, that when this time comes, the investor will not be able to find as good an investment as what he had.