WiseAlpha’s educational series: Teaching you everything you need to know about the bond market and more.
All investments involve risk, and bonds are no exception. Some of the main risks relating to bonds will be discussed in this blog.
Risk of default
The risk that the company may be unable to return all or some of the money advanced to them.
In the bond markets this is known as a default. A default doesn’t necessarily mean that as a bondholder you will lose the money you invested because this depends on the severity of the financial difficulty the company is in.
Sometimes a simple rescheduling of the payment of the debts (which the bonds will be) with lenders can solve the problem and bondholders can ultimately receive the full face value of the bond back.
In more serious instances where the company cannot continue trading as a going concern the assets may need to be liquidated and bondholders may receive back less than the face value of the bond.
Market price risk
Bonds can be purchased at a premium or discounted price to the par value of the bond (par would be a price of £100 per £100 of bond principle).
So for example paying a premium for a bond would mean paying a price above £100 and a paying a discount would mean paying a price below £100.
The price paid by the investor initially could fluctuate from day to day according to the balance of supply and demand from all investors in the market, creating a paper profit or loss.
Prices can be driven by changes in central bank interest rates, the perception of the general and underlying credit risks of the company and liquidity preferences of market participants.
Thus, if the investor needs to sell the asset to retrieve funds they could face a risk of some capital loss if the price has moved against them. It is important to note that bond price volatility is significantly lower than in the equity or stock market.
Early prepayment risk
Some bonds have a feature structured within them that allows bond issuers to refinance or replay their debt to lenders. They’re named “calls”.
This can be disadvantageous to the holder. Whilst the investor fully receives back their capital and interest at the time of the issuer calling the bond, the investor then needs to find a new investment for the money returned (“Reinvestment risk”).
However, such features are clearly laid out in the bond prospectus, so investors can be aware of this when making their investment decision.
“Risk comes from not knowing what you are doing.”Warren Buffet
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