Risks
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Fixed-income securities are generally considered safe investments compared to equities and other assets such as real estate. As with any investment, however, there are certain risks to consider. In particular, investors in fixed-income securities should consider the following risks:
» Credit (or default) risk- The owners of fixed-income securities are primarily concerned with the issuer’s ability to make timely payments of interest and principal. If payments are not made on time, the issuer is said to be in default.The risk that an issuer will default on interest or principal payments is commonly called credit risk, although the more accurate term is default risk.
Market participants use credit ratings as an important consideration in determining credit risk. The risk related to the issuer’s credit strength also determines the additional yield that non-government fixed income securities provide over government issues.
» Market (or interest rate) risk- The price of a fixed-income security moves in the opposite direction to a change in interest rates. In other words, as rates rise, the price of the fixed-income security falls, and as rates fall, prices rise. Market risk (also called interest rate risk) is the risk that prices will fall in tandem with rising interest rates. When a fixed-income security is held until maturity, this risk is not a concern. However, for investors who plan to sell the instrument before maturity, market risk is a factor to consider.
» Reinvestment risk- The yield to maturity quoted on a debt instrument assumes that the coupon interest received can be reinvested at a rate of return equal to the yield to maturity. However, because interest rates fluctuate, this may not be the case. Reinvestment risk is the risk that an investor will be forced to accept a lower yield, and hence a lower rate of return, than originally anticipated. Reinvestment risk does not arise if the bond is a zero-coupon bond.
» Timing (or call) risk- Many bonds contain embedded option, such as call options that allow the issuer to call the debt instrument prior to maturity. The risk that the issuer will exercise a call option is known as timing risk (or call risk). Another type of option is a prepayment option, which allows the borrower to pay down a portion of the principal amount of the loan before maturity. Both types of options represent a disadvantage to the investor because the cash flow of the investment is not certain. A call is exercised when it is an advantage to the issuer (and therefore most often a disadvantage to the investor). Any opportunity for capital gains due to falling interest rates is therefore capped by the call feature. To compensate for these disadvantages, callable bonds normally carry a higher yield.
» Yield curve (or maturity) risk- Investors may choose from many different debt instruments with varying maturity dates. The choice of term is often determined by their specific investment needs, including their perception of which maturity offers the best rate of return. Yield curve risk (also called maturity risk) is the risk that changes in the shape of the yield curve will cause debt instruments with different maturity dates to change in value at different rates than originally expected.
» Inflation (or purchasing power) risk- Inflation risk (also called purchasing power risk) is the risk that the purchasing power of a currency will change over time. Inflation is a serious concern for investors in fixed-income securities with fixed coupon rates. The actual amount of interest and principal payments is known in advance; however, if the rate of interest is ultimately less than the rate of inflation, then the purchasing power of the investment declines.
» Marketability (or liquidity) risk- Liquidity risk (also called marketability risk) concerns the ease with which a fixed-income security can be sold prior to maturity at or near its true value. The difference between the bid and the offer price of a marketable debt instrument indicates the liquidity of the issue. As the spread widens, liquidity decreases.
» Political and legal risk- Two closely related risks are political risk and legal risk. These risks relate to potential changes to a country’s governmental policies or laws, which may have an adverse effect on the value of fixed-income securities. For example, as a result of changes to laws governing taxes and allowable investments in a particular country, the government of that country might apply withholding taxes on interest payments to foreign investors. Or it might declare tax-exempt bonds no longer tax-exempt, or prevent pension funds from holding certain classes of securities. Each of these actions would likely lower the market price of the affected securities.
» Event risk- Natural disasters, industrial accidents, corporate takeovers, and lawsuits can all impair a borrower’s ability to meet its financial obligations. The risk of such incidents occurring is called event risk.
» Sector risk- Fixed-income securities in different sectors of the market may respond differently to economic, financial, environmental, or interest rate changes relative to other sectors. The risk that the securities of a company in a particular sector will underperform in response to such changes is called sector risk.