Bond yield risk is the possibility of investment losses brought on by an increase in the going rates for brand-new debt instruments. For example, if interest rates increase, the secondary market value of a fixed-income investment or a bond will decrease. The price and yield have an inverse relationship, and if the yield rises, the investor runs the danger of losing money. The danger posed by these shifts in interest rates includes the need to reinvest earnings at a rate lower than what the resources were previously earning and the possibility that bonds would have a negative rate of return when inflation rises sharply.
The inverse relationship between yield rates and bond prices is the first concept a bond buyer needs to comprehend. Bond prices increase as interest rates decrease and often decline as interest rates rise. This occurs because investors strive to lock in or capture the highest rates possible for as long as they can when yield rates are declining. To achieve this, they will purchase current bonds that offer interest rates above the going market rate. Bond prices rise as a result of this increase in demand (Del Negro et al., 2019). On the other hand, if the current interest rate is rising, investors would instinctively sell bonds that offer lower interest rates, which would drive down bond prices.
Reinvestment risk, or the risk of having to reinvest proceeds at a lesser rate compared to previous earnings, is another threat bond investor’s face. This risk manifest when interest rates decline over time and the issuers exercise callable bonds. The bond can be redeemed by the issuer before it matures thanks to the callable feature. The bondholder as a result receives the main payment, which frequently comes at a small premium above the par value. The drawback of a bond call is that the investor is left with a large sum of money that they would never reinvest at a similar yield. This reinvestment risk has the potential to reduce asset returns over time. Investors receive a higher yield on the bond to compensate for this risk than they would on a similar bond that is not callable. Active bondholders can try to reduce portfolio reinvestment risk by stupefying the potential call dates of different bonds.
In essence, when an investor purchases a bond, they agree to receive a return rate, either variable or fixed, over the duration of the security. When inflation and the cost of living rise than income investment, investors will experience a decline in their purchasing power and, after accounting for inflation, a negative rate of return might be experienced (Del Negro et al., 2019). The investor’s exact rate of return is -1% when inflation increases by 4% following the bond purchase as a result of the loss in buying power.
An investor is buying a certificate of debt when they buy a bond. In other words, the business must eventually repay with interest. Many investors are unaware that corporate bonds rely on the issuer’s ability to repay the loan and are not fully backed by full confidence and credit. Investors must take into account the potential for default and account for this risk when making investment decisions. Before investing, some analysts and investors will look for a company’s coverage ratio as one way to assess the risk of default (Drechsler, Savov & Schnabl, 2021). They will evaluate the cash flow and profit statements of the company to ascertain its net margin and cash flow before comparing it to its debt servicing costs.
Major rating agencies like Poor’s Ratings and standard Services and Moody’s Investors Service routinely assess a company’s capacity to function and repay its debt obligations. Investors heavily rely on the judgments and choices made by these agencies. Banks and lending organizations will take heed and may demand high interest rates for future loans if an issuer’s corporate credit rating is poor (Fabozzi & Fabozzi, 2021). This could damage current bondholders who may have been trying to sell their stakes and have a negative effect on the company’s capacity to pay down its debts.
Low bond liquidity also causes price volatility which is a risk factor. Government bonds usually always have a ready market, but business bonds can occasionally be very different animals. Due to a crowded market with few investors and buyers for the bond, there is a chance that an investor won’t be able to swiftly sell their corporate bonds. Low purchasing interest in a specific bond issuance can cause significant price fluctuation and have a negative effect on the total return received by the bondholder upon selling. You can be compelled to accept a much lower price than anticipated when selling your bond position, similar to equities that sell in a thin market.
References
Del Negro, M., Giannone, D., Giannoni, M. P., & Tambalotti, A. (2019). Global trends in interest rates. Journal of International Economics, 118, 248-262. Web.
Drechsler, I., Savov, A., & Schnabl, P. (2021). Banking on deposits: Maturity transformation without interest rate risk. The Journal of Finance, 76(3), 1091-1143. Web.
Fabozzi, F. J., & Fabozzi, F. A. (2021). Bond markets, analysis, and strategies. MIT Press.