Tuesday 17 March 2015 by Elizabeth Moran Education (basics)

The top 10 bond risks you need to know

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

risk on a diving board

In recent years, bond investors have been attracted to fixed rate bonds, in part because of their expectations that interest rates will fall leading to a capital gain if they sell prior to maturity. They have been rewarded with double digit returns, especially on long dated, low risk, fixed rate and inflation linked bonds.

A more recent strategy has been to invest in US dollar denominated bonds in the expectation that the US dollar would appreciate against the Australian dollar. This has generally been a rewarding trade for wholesale investors, but some investors in high risk companies have seen gains from the appreciation of the US dollar outweighed by falls in the price of the bond caused by an increase in perceived credit risk of the company.

Foreign currency bonds continue to be attractive to those investors who expect the US dollar to appreciate further against the Australian dollar.

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.

There are many bond risks, the top 10 on my radar are:

  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.
  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. This is also known as duration.

    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.

    Companies have the right to repay the bond before the final maturity date or leave it on issue on specific call dates. Companies will generally act in the best interests of the company. 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. However, regulatory changes since the GFC are changing that balance with regulators ensuring the decision is primarily based on the cost of funding.

    If a company fails to call a bond and the maturity date is extended it is likely the value of the bond would fall on the secondary market.

  4. 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 re-investment risk in that the investor may be reinvesting in a less favourable environment (one with a lower interest rate).
  5. 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.

  6. 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.
  7. Exchange or currency risk – arises from moves in foreign currency rates. Can be divided into transaction risk where currency fluctuations impact the proceeds of specific transactions and translation risk which affects the value of assets and liabilities.
  8. 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.
  9. 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 (or Tier 2) and hybrid (or Tier 1) securities. The non-viability clause required in any new subordinatd and Tier 1 security issue is a good example of regulatory risk.
  10. Event risk – risk due to unforeseen events, for example a company making a large acquisition.

It is important for investors to understand where their investments sit in the capital structure as this directly correlates to the risk involved (see Just like property, location matters in bonds). 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.

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