Analysis of Risk Types in Bonds

2023-10-10
Summary:

Bond investment mainly focuses on credit, liquidity, and interest rate risks. Inflation, exchange rate, and policy risks also need to be considered.

The risk of bonds is a very important part of financial asset analysis. In investment decisions, it is not only important to pay attention to the returns of bonds but also to minimize risks as much as possible.

Analysis of Risk Types in Bonds

For bonds, risks mainly include the following three aspects:

  1. default risk

    Firstly, there is the risk of default, which many people are familiar with. Bonds include Treasury bonds, municipal bonds, etc. Treasury bonds are usually guaranteed by national credit, and default risk is almost negligible. However, corporate bonds have different risks, as the company's operations may fluctuate, leading to an increase in credit risk. Therefore, the first thing to focus on is credit risk or default risk.


    Regarding credit risk, bonds with different credit ratings vary. Credit ratings are divided into three A levels, two A levels, and three B levels. It should be noted that the maturities of these bonds are the same. By comparing bonds with different credit ratings, the 3B-level corporate bond has the highest risk, while the AAA-level corporate bond with the best credit has the lowest risk. This is easy to understand because bonds with higher risks need to provide higher returns to attract investors and compensate for potential risks.


    It should be noted that these ratings are not determined by individuals but rather by rating agencies. There are three major rating agencies in the United States, including S&P, Moody's, and Fitch, which provide credit ratings for bonds.


  2. Liquidity risk

    The second characteristic of bonds is liquidity risk. Liquidity refers to the degree to which an asset can be easily bought and sold. For example, a short-term Treasury bond has high liquidity, but medium- and long-term bonds have low liquidity. Different types of bonds also have different liquidity because they contain different information and characteristics, which makes it more difficult for them to trade in the market. For bonds with low liquidity, investors usually need to pay a premium to compensate for the risk.


    Liquidity risk is influenced by various factors, including bond types, maturities, and trading venues. For example, treasury bonds usually have higher liquidity than non-treasury bonds because they have no credit risk and are relatively standardized investment options.


  3. Interest rate risk

    The third type of bond risk is interest rate risk, which refers to the fluctuation of bond prices with market interest rate fluctuations. Bond prices are determined based on market interest rates or discount rates, and as market interest rates rise, bond prices decrease, and vice versa. This means that investors may face the risk of a decrease in bond value, which is known as interest rate risk.


    Interest rate risk is influenced by characteristics such as the coupon rate, maturity, and included options of a bond. Usually, the longer the term of a bond, the greater the interest rate risk, as bond prices are more susceptible to market interest rate fluctuations.


In addition to the three main risk categories mentioned above, the risk categories of bonds also include:

  1. Inflation risk

    Inflation risk refers to the fact that if the inflation rate is higher than the bond interest rate, the actual return on the bond will decrease. Because the face value and interest payment of a bond are fixed, if inflation leads to a decrease in purchasing power, the actual value of the bond will also decrease.


  2. exchange rate risk

    Exchange rate risk refers to the risk arising from exchange rate fluctuations when investors hold foreign currency bonds. When the domestic currency depreciates, the local currency value of foreign currency bonds also decreases. In addition, when paying the interest and principal on foreign currency bonds, it is necessary to convert the domestic currency into foreign currency, which is also affected by exchange rate fluctuations.


  3. Policy risk

    Policy risk refers to the impact of government policy changes on the bond market. The adjustment of government policies may lead to changes in market supply and demand, thereby affecting bond prices. For example, the government may lower interest rates, causing bond prices to rise; the government may also strengthen regulatory efforts, resulting in certain bonds being unable to be listed for trading.


Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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