Bonds – Default Risk Is The Least of Your Worries
U.S. Treasuries are considered one of the safest investments in the world. Why? Just take a look at the yield on the 10 year bond; despite the deadlock in Washington and the media induced fear that the U.S. may default on its debts, the world still believes that the U.S. will not renege on its debt. As a matter of fact, while the stock market declined recently because of inaction in Washington, the yield on the 10-year bond actually dipped below 3 percent (when investors buy Treasuries, the yield goes down). Because U.S. Treasuries are perceived to be risk-free, they are used as a bellwether for other bonds as well. Corporate and municipal bonds are compared to U.S. Treasuries to assess their risk; when the interest rate between a non-Treasury bond and a Treasury bond is wide (also known as spread), the Treasury bond is considered riskier, and vise versa. But just because the U.S. Treasury is assumed to be default proof, it does not necessarily mean that it is risk free. While default risk is important to consider, investors must also recognize that bonds exhibit other risks beyond default risk. Below is a list of the different types of bond risks investors should be aware of.
Default risk – is the risk the borrower (U.S. government, municipality, or a corporation) will not make interest payments as promised. Investors perceive U.S. Treasuries to be default proof because they believe the U.S. will always pay its obligations. Many investors falsely believe that municipalities are also default proof, but in 1994, Orange County, California defaulted on its debts.
Interest rate risk – is the risk that interest rates will change after issuance. For example, assume an investor buys a 10 year bond for $1,000 paying 4 percent annually, which means the investor will receive $40 per year for 10 years. The investor is exposed to interest rate risk because if interest rates increase, the investor will still receive $40, but the price of the bond will decline because no one would want to pay $1,000 for a bond paying 4 percent when the market interest rate is higher than 4 percent; the reverse is true if interest rates decline. The change in the price of the bond given a change in interest rates is measured using a term called duration.
Reinvestment risk – Continuing with the same example from above, as the investor receives $40 in interest payments every year, it is assumed that he/she will reinvest that interest payment at prevailing market rates. If prevailing market interest rates are below 4 percent, the investor is exposed to reinvestment risk because they will reinvest those payments at lower rates.
Liquidity risk – Liquidity is the ability to buy or sell an investment quickly without difficulty. Bonds do not trade the same way as do stocks. Whereas stocks are easily traded throughout the day on an exchange where there are usually thousands, if not millions of shares traded in a single day, bonds (except for U.S. Treasuries) are traded through bond dealers where trades occur much less frequently. This infrequency of trading within the bond market leads to stale prices and liquidity risk.
Spread risk – As mentioned in the opening, U.S. Treasuries are used as a bellwether for other bonds, and a bond’s riskiness is measured by the spread between its yield and that of a comparable Treasury. Hence, spread risk is the risk that the bond’s yield will widen against that of a comparable Treasury; the wider the spread, the greater the risk of the bond.
Downgrade risk – Bonds are rated by major credit rating agencies, despite whether investors still trust the rating agencies given the Mortgage Backed Security debacle. Nevertheless, bond ratings are important for many investors, especially institutional investors such as banks, endowments, pensions, etc. Such institutions have policies that prohibit them from owning low grade bonds, so they rely on the ratings to screen bonds. Downgrade risk is the risk that a bond will be downgraded by one or more of the credit rating agencies and lead to a sell off among those bonds.
I identified six risks of investing in bonds. However, there are additional risks that apply to complex bonds as well. When bonds have more unique features such as calls, puts, zero coupons, etc., the risks multiply. Many investors wrongly assume that if they invest in a bond and hold it to maturity, that they are not taking any risk. But as you can see from the various risks identified above, investors must be aware of the complexities associated with investing in bonds, and learn how to manage those risks.
Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” investment management firm specializing in working with medical professionals. Contact Ara at firstname.lastname@example.org or on the web at www.acapam.com for a complimentary consultation.