13.4 Fixed Income 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 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.
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- If the firm is in violation of any of the technical terms (“covenants”) of its loan agreement (“indenture”), it may also be considered in “technical-” default even if it is timely in making all its payments.
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- Note that interest must be paid before any dividend payments on preferred and common stocks may be made.
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- If a borrowing company defaults on its debt, it may thus become insolvent which would lead to bankruptcy.
Inflation Risk– the risk that the return, i.e., the interest payments, will be eroded over time by inflation, i.e., a reduction in the purchasing power of the interest payments.
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- Note that, in most cases, interest payments are fixed.
- Many governments sell inflation-linked, or inflation-indexed bonds that have payouts linked to the inflation rate. The United States Treasury sells Treasury Inflation-Protected Securities (TIPS).
Interest Rate (or “Price”) Risk – the negative effect on market values, or prices, due to rising levels of general interest rates.
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- Interest rates and prices are inversely related. If rates go up, ceteris paribus, bond market prices go down.
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- 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 thus its market value will go down.
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- 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 holding period return.
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- When the investor purchases a bond, s/he has some expectation to either spend the money or to reinvest the interest payments at some anticipated future rate. Should rates go down, the reinvestment rate will be less than expected (or less than it was at the time of purchase) 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.
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- Note that interest rate and reinvestment risks are inversely related to (i.e., the opposite of) one another.
Country or Sovereign Risk – for example, war, changes in administration, etc.
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- When there is war, people nervously sell stock, as occurred in December 1990 when the Gulf War broke out. When Donald Trump was elected U.S. President in November 2016, the stock market rose sharply.
Foreign Currency Risk – possible negative effect of repatriation of funds
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- In general, most U.S. companies have substantial assets domiciled or revenues generated overseas. These funds may be repatriated or brought home at an unfavorable exchange rate. Thus, even American companies bear some foreign currency risks even though their stocks are dollar denominated.
Notes:
- “Nominal” rates (or prices) are not adjusted (lower) for inflation.
- “Real” means “corrected” for inflation, i.e., adjusted. The real rate will be lower than the nominal rate, given some inflation.
- The following phrases all usually mean percent: return, rate, yield, margin, bracket.