1.2 Fixed Income Type Risks

Risk in theoretical finance is defined mathematically usually as the chance or extent to which the actual return may differ from the required or expected return.

“Differ” allows for the actual or “realized” return to be either less than or greater than the expected return.   

From the investor’s perspective, bond risks may be divided into the following qualitative components:

• Liquidity Risk – the risk that the security cannot be converted to cash at its reasonable intrinsic or “fair market value” due, possibly, to a lack of buyers.

• Credit- or Default Risk – the possibility that a corporation may, in the worst case, go bankrupt, or, in a lesser case, not honor its interest and other related payments timely and in full.

• If the firm is in violation of any of the technical terms of its loan agreement (“indenture”), it may also be considered in (“technical-”) default even if it is timely in making all its payments.

• Note that interest must be paid before any dividend payments on preferred and common stocks may be made.

• Inflation Risk – the risk that the return, i.e., interest payments, will be eroded by inflation, i.e., a reduction in the purchasing power of the interest payments.

• Note that, in most cases, interest payments are fixed.

• Interest Rate (or “Price”) Risk – the negative effect on market values, or prices, due to rising levels of general interest rates.

Interest rates and prices are inversely related.  If rates go up, ceteris paribus, bond market prices go down.

Think of it this way, if you already own a bond and interest rates, in general, go up since the time of purchase, then new bonds will be issued at higher rates than your bond.  All else equal, that will make your bond relatively less attractive and its market value will go down.

Possibly more than any other risk, this is tied into macroeconomic factors, including Federal Reserve policies.

• Reinvestment Rate Risk – the risk that cash interest payments received during the life of a bond will be reinvested at less than the rate originally expected, thereby reducing the overall return.

When the investor purchases a bond, s/he has some expectation to reinvest (or perhaps to spend) the interest payments at some anticipated rate.  Should rates go down, the reinvestment rate will be less than expected and the investor’s savings at the bond’s maturity (i.e., the bond’s “future value”) will have accumulated to less than that which was originally anticipated.

Note that interest rate and reinvestment risks are inversely related to (i.e., the opposite of) one another.

• Country- or Political Risk – for example, war, changes in administration, etc.

• Foreign Currency Risk – possible negative effect of repatriation of funds.