How risky are Bonds?
In the US, the total value of bonds that have been issued is roughly double the total value of company shares. With such a vast quantity of bonds in circulation, it should be no surprise that the risk associated with them varies enormously.
In this article we introduce some of the main areas of risk associated with bonds, what they mean and how they are measured.
Different types of risk
There are four main types of risk that we will consider here. These relate to inflation, interest rates, the viability of the borrower, and the overall market.
This is the speed at which prices are rising. If a basket of goods cost £100 last year but that same basket costs £105 this year, then annual inflation can be said to be at 5%. The implication of this is that if inflation continues at 5%, then you’ll need £110.25 (£105 plus a further 5% of this amount) this time next year to buy the same basket of goods.
To put it another way, inflation reduces the real value or buying power of cash. The higher the rate of inflation, the faster the value of cash is reduced.
This is very significant for bonds because most of them pay a fixed annual return or “coupon”. So if you hold a £100 bond paying an annual coupon of £5, from two years’ time onwards, the bond and its coupon payments will be losing value in real terms.
Bond issuers will know what the expected rates of inflation are, and will try to offer a coupon that is high enough to tempt sufficient investors to buy their bonds. But if inflation expectations rise after the bonds have been issued, then those bonds will become less attractive and could be sold by bondholders to other investors.
Many investors will conduct detailed calculations of what they need and buy bonds with the express intention of holding on to those bonds until they expire. For those bondholders, changes in inflation might be irrelevant. But for many investors, seeing the value of their capital being eroded may be unacceptable, and they might be forced to sell some bonds.
If lots of bondholders feel the same way, then the demand for a given bond may fall, sending its price down (see previous document in this series entitled, “Introduction to bonds” for more information). The price and yield of a bond move in opposite directions, so as bondholders sell, other investors might be tempted to buy the bond as its yield rises.
But what about the issuer? They have already sold the bond so it might seem irrelevant to them what happens to the demand for and price of the bond after it has been issued. It’s not.
Bonds are usually issued because the company or public body selling the bond needs to raise more cash than it has in regular revenues, or that it can raise in more traditional means from a bank. This might enable the issuer to deliver a large project, the revenues of which might come in slowly over time.
The reality for many issuers, then, is that when one bond matures, in order to repay the investors, they have to replace it with a new bond. If yields have gone up in the meantime, they will have to increase the coupon that they offer in order to attract investors. In other words, borrowing will have become more expensive for the issuer.
Inflation risk can come as part of a double-whammy. If the Bank of England and other central banks expect inflation to stay above the target level (2.0% in many developed countries such as the UK), then they might increase interest rates.
Higher interest rates make borrowing more expensive for everyone, reducing the amount of money people and businesses have to spend. That reduced spending means that demand tends to fall and, as is usually the case, if demand falls then so do prices.
But there is another effect. Rising interest rates can make savings deposit accounts more attractive as those might carry lower risk of the borrower failing to maintain payments. For example, in the UK, some bank deposits are guaranteed by the government through its Financial Services Compensation Scheme. In some instances, if the bank were to go bust, the first £85,000 held by a customer within the given bank group could be reimbursed by the government.
Viability of the borrower
This risk of the borrower going under is known as the credit risk. Banks are generally recognised as having a relatively low likelihood of going bust. By contrast, some of the companies and public bodies that issue bonds (i.e. borrow from investors) are deemed to be more at risk of failing to maintain payments.
So if interest rates go up, investors could be attracted away from bonds with their fixed coupons, and towards banks with their variable interest-rate paying deposit accounts and potential lower credit risk ratings.
The final broad area of risk that we shall consider is that of market risk. If investors lose confidence in a broad range of assets (such as happened in the extreme during the financial crisis a decade ago) then the demand for and price of many assets can fall.
This can affect different bonds in different ways. For example, during the financial crisis, investors wanted to move money out of assets that had higher market risk and into ones with lower market risk. Bonds issued by the US government are widely perceived to be very low risk in this regard, which is why the demand for and price of them rose during the financial crisis.
By contrast, bonds that carried a much higher market risk fell out of favour with their prices dropping as a result.
This begs the question as to how these risk ratings are established and by whom.
There are three major credit rating agencies who investigate companies, countries and public bodies in order to determine how vulnerable those entities are to the types of risk described above. These three companies are Standard & Poor’s (S&P), Moody’s and Fitch.
They look into the credit-worthiness of companies and public bodies i.e. what levels of risk would be associated with lending to those entities. The higher the overall level of risk, the higher the rate of potential return that lenders will demand.
The answer to the question of how risky bonds are, is not a simple one. It depends on the various different levels of risk associated with the bond including its remaining life span, the country in which it is issued and the stability of the entity issuing the bond. There are other factors as well, but we can consider those in later articles in this series. For now, a good rule of thumb is to remember that the lower the levels of risk associated with a bond, the lower the yield tends to be.
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