Risks associated with investing in bonds, Financial Management

  • Interest rate risk is the risk wherein the investor in bonds faces the risk of a fall in his bond price as and when there is a rise in the market interest rates. For an issuer of a bond, it is a risk of an adverse effect of interest rate movements on an issuer's profits or balance sheet.

  • Yield curve risk may be a 'term structure risk' or 'repricing risk.' The term structure risk is the risk that is connected to the changes in the fixed income term structure. Repricing risk is the risk that occurs when the interest rates are required to be reset either due to maturities or floating rate resets. Repricing risk is felt suitable as an alternative name for term structure risk.  

  • Callable bonds tend to have certain disadvantages like uncertainty, decline of interest rates below the coupon rate, etc., by which the investor is exposed to call risk. When these disadvantages are made applicable to mortgage-backed and asset-backed securities where the borrower can prepay principal prior to scheduled principal payment dates then the risk involved is prepayment risk.

  • Reinvestment risk is the risk involved in reinvesting the proceeds from the issuer against callable bonds.

  • Credit risk is a risk to which a bond investor is always exposed to because it is the risk of loss due to issuer's inability to pay the loan amount or any other line of credit. It is of three types - default risk, credit spread risk and downgrade risk.

  • Exchange rate or currency risk is the risk that arises from the change in price of one currency against other.

  • Inflation or purchasing power risk is the potential risk or loss in the value of cash due to inflation. It arises from the decline in the value of a security's cash flows due to inflation, which is measured in terms of purchasing power. 

  • Volatility risk is the risk based on the potential for the volatility of the underlying bond or the market's perception of the underlying security. This is the risk the holder of an option is exposed to.

  • Event risk is the risk involved where the issuer's capability to make interest or principal payments changes all of a sudden due to certain unexpected factors. The factors may be natural calamities, corporate takeover, regulatory risk or political risk.

Posted Date: 9/10/2012 1:31:41 AM | Location : United States

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