What You Should Know
Risks of Investing in All Types of Bonds
Duration risk: The duration of a bond is a measure of its price sensitivity to interest rates movements, based on the average time to maturity of its interest and principal cash flows. Duration enables investor to more easily compare bonds with different maturities and coupon rates by creating a simple rule: with every percentage change in interest rates, the bond’s value will decline by its modified duration, stated as a percentage. Modified duration is the approximate percentage change in a bond’s price for each 1% change in yield assuming yield changes do not change the expected cash flows. For example, an investment with a modified duration of 5 years will rise 5% in value for every 1% decline in interest rates and fall 5% in value for every 1% increase in interest rates.
Bond portfolio managers increase average duration when they expect rates to decline, to get the most benefit, and decrease average duration when they expect rates to rise, to minimize the negative impact. If rates move in a direction contrary to their expectations, they lose.
Inflation risk: Inflation causes tomorrow’s Euro, pound sterling or dollar to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices. Inflation-indexed bonds are structured to remove inflation risk.
Market risk: The risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics.
Selection risk: The risk that an investor chooses a security that underperforms the market for reasons that cannot be anticipated.
Timing risk: The risk that an investment performs poorly after its purchase or better after its sale.
Risk that you paid too much for the transaction: The risk that the costs and fees associated with an investment are excessive and detract too much from an investor’s return.
Credit risk: if the issuer or the collateral backing the issuer runs into financial difficulty or declares bankruptcy, it could default on its obligation to pay the bondholders.
Liquidity risk: if the bond issuer’s credit rating falls or prevailing interest rates are much higher than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a buyer. Bonds are generally more liquid during the initial period after issuance as that is when the largest volume of trading in that bond generally occurs.
Currency and exchange-rate risk: Currencies—the Euro, the dollar, pound sterling, etc.--move in relationship to one another. If you have investments in other currencies than your own, the risk is that the currency your bond is in will appreciate. When the bond’s proceeds are converted back into your own currency, the proceeds will be worth less.
Sovereign risk: The risk that the government issuing the bond will act in ways that negatively affect the value of the bond.
Event risk: The risk that a bond’s issuer undertakes a leveraged buyout, debt restructuring, merger or recapitalisation that increases its debt load, causing its bonds’ values to fall, or interferes with its ability to make timely payments of interest and principal. Event risk can also occur due to natural or industrial accidents or regulatory change.