The Risks Incurred by Investing in Bonds
The risks incurred by investing in bonds are usually divided into the following categories:
Interest rate risk.
Early redemption risk.
Credit risk relates to the issuer’s potential inability to fulfill their financial obligations stemming from the bonds. An issuer who does not meet the payments of interest and/or principal is called “insolvent”, and is said to be “in default”.
Interest Rate Risk
Interest rate risk results from changes in the federal interest rate. When this rises, the price of existing bonds falls. Conversely, when the federal interest rate is lowered, then the price of existing bonds rises. The later the maturity date of a bond, then the more responsive it is to changes in the interest rate.
Inflation risk reflects the potential loss of purchasing power, i.e., a situation when fewer goods can be bought with the flow of income from a bond than the bond purchaser had expected when the bond was purchased. The higher the inflation rate in the economy, then the greater the erosion of purchasing power, particularly when the bond has a fixed interest rate. One of the methods of dealing with inflation risk is to buy index-linked bonds with the principal and interest adjusted according to the consumer price index.
Early Redemption Risk
Early redemption risk refers solely to bonds that include an early redemption clause. The investor is exposed to the possibility that they will lose possession of the bond in spite of their desire to retain it.
Issuers usually choose to exercise their early redemption options when the federal interest rate has fallen. In this case, the issuer will be able to sell new bonds at a lower rate of interest thereby reducing their interest payments.
Reinvestment risk refers to an investor who will be obliged to seek additional bonds as a substitute after their bonds have matured. It is possible, however, that on the maturity date, the federal interest rate will be lower than in the past, and the investor will be unable to find a substitute for the bonds that will provide them with a comparably desirable interest rate.