What are the risks of investing in a bond
Bond Risk Analysis
What are the risks of investing in a bond. As compare to other financial assets or securities fixed income securities are considered to be less risky. Though they are less risky, are not entirely risk-free securities. Therefore, the investment in bonds is a function of various types and sources of risk. The actual return from a bond may differ from the expected return due to defalcation or changes in market interest rate. Both systematic and unsystematic risk can influence the return from the investments in bond.
However, the major risks involved in investments in bond are default risk and interest rate risk.
Default risk refers to the failures of the company to repay principal and/or interest thereon on the stipulated dates. Inefficient financial performance and management inefficacy lead to default risk. Default risk arises due the nonpayment of whole or a part of interest and principal. I n such a situation, investors in bonds suffer losses which reduce their return from bonds. Through credit rating such risk can be identified and measured. Credit rating is a process of qualitative analysis of the company’s business and management and quantitative analysis of the company’s financial performance.
Interest rate risk
Since the price of a bond rarely moves in financial markets, the major income from the bond represents the coupon interest rates. An investor in bond generally receives these interests annually or semi-annually. Hence, the investors can reinvest their interest amounts at the prevailing market interest rate so that interest on principal begets interest. An investor can do so, so long as he holds the security. Investor can sell the bond off at a price which may be equal to the face value. During the holding period, market interest rates may change. If the interest rate increases, the investor would be able to reinvest the annual interest earned from the bond at a higher rate which will maximize the return. In addition to that bond price will fall below its face value as the market interest rate moves up. Therefore, investor would suffer a loss if he sells the bond. If the lose on sale exceeds the gain on reinvestment, investor will suffer a net lose on account of the rise in market interest rate. In contrast, if the interest rate declines, opposite dimension will exist. The investors have to reinvest the amount of interest at a lower than what was expected. Since the market interest declines, the bond price will move above the face value because the demand of that bond would become high as its rate of return is higher. Under these circumstances, the investors would incur lose in reinvesting the interest while they will gain on selling the bond. Investors in bond experience variations in expected rate of return because of the changes in the market interest rate. This variability in return is termed as interest rate risk. Interest rate risk is the result of two components like reinvestment of annual interest and the capital gains or losses on the sale of the bond at the end of the holding period. When the market interest rises, there is the possibility of making gains from reinvestment’s of interest but there may exist a lose on sale of the bond and vice versa. However, reinvestment risk and price risk are the decomposition s interest rate risk.
Both reinvestment risk and price risk have an opposite effect on the return of bond. Investor can eliminate interest rate risk by holding the bond for its duration. If the holding period significantly differs from the duration of the bond, interest rate risk will exist for the bond.
What are the risks of investing in a bond.