Wednesday 17 October 2018 by Elizabeth Moran Opinion

The top 10 bond risks you need to know

Bonds are always lower risk than shares in the same company, but do carry some of the same risks. They also have unique risks that can be used to your advantage under various economic conditions.

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Risk means different things to different investors. To some it means uncertainty or possible volatility in returns and to others the possibility or odds of losing money or the chance of unwinding a position at a loss. I think it’s both. The upside is higher possible returns.

Two prevalent risks

Rising US interest rates have been drawing foreign investment back into USD, so global interest rates are expected to follow US rates higher in order to compete for funds. For the last year we’ve been encouraging clients to add floating rate notes to their portfolios to take advantage of a changing rate environment. Unlike fixed rate bonds, where bond prices fall if interest rates rise, floating rate notes are more capital stable and higher interest rates mean higher income for investors. 

Even though many USD denominated bonds are fixed rate, there is another risk/ reward consideration - the possible changes to the currency. Some investors would still chose to invest in fixed rate USD bonds as a hedge against the AUD.

Interest rate and currency risks are two of the top 10.  

The complete list is as follows:

 

  1. Credit or default risk – this is the risk that the bond issuer may be unable to meet the interest and/or principal repayments when due, defaulting on the bond. Generally, the higher the credit risk of the issuer, the higher the credit margin that investors will expect in return. If perceived credit risk increases, the bond price should fall.

     

    Sub sections of credit risk:

     

    Political or country risk – the risk of loss when investing in a given country caused by changes in a country’s political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of profits. Since the GFC, political and sovereign risks have been high. Sovereign risk is essentially the credit or default risk of a country but also results in heightened risk of political and regulatory changes.

    Regulatory risk – the risk of regulation changes on a business or industry. This is particularly relevant for financial institutions such as banks and insurers as regulatory changes may have material changes on the value and call risk of regulatory capital securities such as subordinated bonds (Tier 2) and hybrid (Tier 1) securities. The non viability clause required in any subordinated and Tier 1 security issue is a good example of regulatory risk.

     

  2. Interest rate risk – the risk associated with an interest bearing asset, such as a loan or a bond, due to variability of interest rates. This mainly affects fixed rate bonds. When the expectation of interest rates is that they will rise, fixed rate bond prices will fall, and the reverse is also true. Expectations of lower interest rates will see fixed rate bond prices rise.

     

    Floating rate bonds are more capital stable given interest is adjusted quarterly to reflect changes in the underlying benchmark rate.

     

  3. Call risk – the risk faced by a holder of a callable bond that a bond issuer will or will not call the bond at the first opportunity.

     

    Callable bonds give companies the right, but not the obligation, to repay the bond before the final maturity date or leave it on issue for the next call date or until maturity. There can be one call date or many call dates depending on the particular issue. Companies will generally act in their own best interest.  For example they would opt to extend maturity if it would cost them more to reissue a new bond or repay at first call if they could refinance at a lower interest rate. Financial institutions will also weigh up reputational consequences of calling early or extending and in the past have placed a very high reliance on reputation. Some financial institution callable bonds are subject to APRA approval before being called.

     

    If a company decides not to call a bond when the market was otherwise expecting it to do so, the value or the price of the bond may fall.

     

    Sub section of call risk:

     

    Early redemption risk – the risk faced by a holder of a callable bond that a bond issuer will take advantage of the callable bond feature and redeem the issue prior to maturity. This means the bondholder will receive payment on the value of the bond (typically at par) even if the bond was trading at a premium (over its $100 face value). In good economic times, there is also reinvestment risk in that the investor may be reinvesting in a less favourable environment (one with a lower interest rate).

     

  4. Liquidity risk – this is the risk that a security cannot be easily sold at, or close to, its market value.

     

    During extreme events such as the GFC, illiquidity is heightened. Generally the lower the risk of the bond the easier it will be to sell at or close to its market value. Part of the premium for investing in higher risk bonds is to compensate for lower liquidity.

     

  5. Inflation risk – mainly associated with fixed rate bonds where there is a set return that may not cover inflation if it starts to spiral. Inflation linked bonds directly hedge inflation risk while floating rate notes would somewhat protect investors, with expectations of higher interest rates to combat inflation likely to increase the underlying benchmark interest rate, typically BBSW, noting that the correlation of inflation to interest rate is not perfect.

     

  6. Exchange or currency risk – arises from moves in foreign currency rates for investors buying bonds denominated in a currency other than the currency of their liabilities. Reflects that any bond price appreciation can be entirely wiped out by unfavourable currency movements.

     

  7. Event risk – risk due to unforeseen events, for example a company making a large acquisition.

     

  8. Counterparty Risk – Is the risk to each party that the other will not live up to its contractual obligations. For example, a typical RMBS transaction would issue multiple floating rate tranches (based on BBSW) and yet many mortgage loans in the portfolio would be fixed or floating but based on the relevant bank’s lending rate. In order to avoid any rate mismatch, the transaction will include an interest rate hedgethat will ensure the mismatch is removed. Likewise for RMBS, many include loans that are supported by lender’s mortgage insurance but this protection is only as good as the insurer. Other example of counterparty risk would include Australian-based issuers (with no overseas operations) issuing USD dollar and entering into a foreign currency swap ensuring that the amount of interest and principal over the life of the bonds are fixed in AUD. If the provider of that hedge disappears, the issuer would suddenly become exposed to FX fluctuations

     

  9. Tax Risk - Withholding tax is charged for investors that invest outside their domestic jurisdiction. It can be overcome by providing a tax file number in Australia or completing a W8-BEN form for US investments. If the tax law changes, there is a risk that tax would be withheld by the issuer and investors would receive less than expected. If the terms and conditions of the bonds allow for that retention, the lower payment would not constitute a default.

     

  10. Structural Risk – In the case of a weak covenant structure, other creditors may be allowed to take a more senior position, pushing down the bond holder’s position in the creditor’s priority queue. For example, an unsecured bondholder with weak covenant protection that allows the issuer to increase secured debt.

 

It is important for investors to understand where their investments sit in the capital structure as this directly correlates to the risk involved. Investors should frequently reassess the return they are receiving and whether this is sufficient given ever changing market expectations of credit risk, call risk and interest rates. Moreover, they should ensure that the additional return for moving down the capital structure compensates for any additional risk.

If you would like to discuss risk further, please call 1800 01 01 81 or your local relationship manager.

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