Now we will see the different risks that the bonds and debt securities face and explain them with the valuation formula.
Interest Rate Risk
Interest rate is the most important risk all the tradable bonds and debt securities are facing. It the market interest rate increases the market price of the bonds will decrease in value because of lower demand among the investors, as the investors will prefer other instruments or other bonds with higher return than the existing bonds in the market.
During the high interest rate environment, the investors sell the existing bonds and buy new bonds with price already reflecting the high interest rate. Because of lower demand, the market price drops. Decrease in market price results in higher yield to maturity. Same way, the decrease in interest rate increases the demand and market price of the bonds, resulting in lower yield. That’s why we say that the bond yield always follows the market interest rate.
If the market price drops because of higher interest rate, the investors lose money and sometime have to book loss if the interest is expected to increase more. That’s why interest rate is the most significant risk for bond investment. As interest rate is very volatile in emerging or developing economies, the bond market of those countries witness more of interest risk than any other developed countries.
The change in interest rate only changes the market value of the bond, not the scheduled coupon payment or the par value of the bond. Long term investors who want to receive the specific coupon payment and the par value at the scheduled time won’t be facing any problem because of the interest rate changes. They do not possess any interest rate risk.
Yield Curve Risk
Yield curve denotes the future projection of the yield with time as a reference. It denotes the short term and long term yield over the time and normally upward inclined as long term interest rate is more than the short term interest rates. Now as the yield rate follows the market interest rate, any changes in the market interest rate cause changes in the yield curve as the short term yield rate is more sensitive to the interest rate changes. Sometimes the interest rate changes lead to shift or change the shape of the yield curve.
Normally investors earn profit by borrowing money at lower short term interest rate and selling bonds at higher long term interest rate. Any changes in the yield curve can change the pattern and lead to loss for the investors. That’s why investors face yield curve risk while investing in bonds or selling them in market.
Call risk is a valid risk only for callable bonds which gives the provision to the bond issuer to call back the bond after certain specified time. When the interest rate falls, the bond price increases because of higher demand and lower yield. High bond price makes the bond issuer to call back the existing bonds at lower price than the market price and reissue bonds with lower coupon rate and lower yield.
This provision is a risk for the investors as they are deprived of the profit resulted out of bond price increase because of increase in interest rate. The call risk increases with the increase in interest rate volatility and more volatile environment prompts the issuer to call back the existing bonds.
Prepayment risk is related to the risk of early payment of the loan or debt by the borrower. Fall in interest rate and improve in credit rating reduce the loan interest rate or make the borrowing cheaper. Borrowers often use this benefit to pay off the existing loans or mortgage much before the scheduled date and refinance the money at cheaper interest rate in order to gain the benefit out of cheaper market interest rate.
This prepayment increases the risk for the loan/mortgage lenders as they have to close the existing loan/mortgage at higher interest rate and issue loan/mortgage at lower interest rate. This reduces their net interest margin and profitability. Prepayment risk increases with interest rate volatility as more volatile interest rate prompts the borrows to prepay the existing loans/mortgages.
Bonds and debt investors reinvest the coupon payment and any earlier received money in market interest rate to gain higher return. Higher market interest increases the return from the reinvestment of the coupon payment or any partial principal payment (for mortgage). If the market interest rate decreases, it decreases the return received out of the reinvestment of the coupon or partial principal payments.
For bonds paying scheduled coupon payments or partial principal payments (for mortgages) are exposed to higher reinvestment risk and the zero coupon bonds with no partial or midterm payment have no reinvestment risk. But as per the interest rate risk view, the zero coupon bonds will be having higher interest rate risk compared to other bonds because of higher Duration.
Bonds paying scheduled coupon payments or partial principal payments (for mortgages) are having lower duration as some part of investment is received much before the final maturity date which reduces the duration or interest rate risk sensitivity.
Credit risk is related to the credibility of the borrower of loan or the issuer of the bonds to pay the coupon, interest or principal payments as promised. Credit risk arises from the delayed or no payment of the borrower.
The situation of not paying the interest or principal as promised is called “Default” and the related risk is called the default risk. It may lead the loan lenders or bond investors to lose money in terms of interest, principal or decreased or delayed cash flow. The worst case can be declaring bankruptcy by the bond issuer or complete default of the loan borrower, where the loan lender or the bond investors lose all of their investment money. Credit risk is also related to government bonds where losing credit rating can lead to lower credibility to pay the interest on the government debt or default risk.
Liquidity risk is a financial risk because of uncertainty of the sufficient liquidity to pay the scheduled interest or principal payment. The shortage of liquidity can arise because of
Because of liquidity problem the loan lenders and bond investors can face default risk or delay in any kind of payment. Also the lower liquidity in the market can make it tough for bond investors to sell the existing bonds are proper market price, thus may force them to sell the bonds at loss to fund any emergency cash needs. Having proper liquidity in the market is very much important for debt or bond investors to realize the proper value while selling the bonds in the market. Liquidity risk for a company can be measured as interest coverage ratio, debt-equity ratio etc.
Exchange Rate Risk
Exchange rate risk is a financial risk which arises from the movement in the currency exchange rate elated to any other foreign currency. Any unfavorable Currency exchange rate movement can erase the gain out of any foreign country bond investment or foreign company debt securities. The main reason behind the same is that the investors has to convert it back to local currency after receiving the interest or principal, any local currency appreciation makes the return of the investment less valued in terms of local currency.
Let us see the currency risk case as an example. Suppose one Indian investor invests inUSgovernment Treasury bill which promises 10% return in next one year. The initial investment amount is 1000 USD and the return will be 1100 USD after one year.
If the current currency exchange rate is Rs 50 per USD and after one year the currency exchange rate becomes Rs 45 per USD because of Rupee appreciation and USD dollar depreciation insideIndia(Rupee is expected to appreciate 10% in next 1 year). In Rupee terms the initial investment is Rs 50,000 and the return will be after 1 year 49,500 which is a loss of 1% on the initial investment.
Though theUSgovernment bond has given 10% return, but because of exchange rate or Rupee appreciation the Indian investor has suffered a 1% loss on his investment. This shows how exchange rate possesses a significant risk over cross-border investments.
Volatility risk is only applicable to bonds and debt securities with call, put and prepayment options. Interest rate volatility increases the probability of using these options and affects the market value of the bonds and debt securities with call, put and prepayment options.
None in the financial market likes interest rate volatility. If the interest volatility increases in the market the investors reduce the exposure in the market and sell or buy back the bonds.
Inflation risk is also a major risk faced by the bond investors. Inflation erases the purchasing power of currency as it increases the price of all the basis articles and services. Higher unexpected increase in inflation has very significant impact on the purchasing power of money in future.
Suppose one investor invests 1000 USD in a zero coupon bond which will mature after 20 years. The investor will receive 1000 USD after 20 years without any cash inflow in between. The high inflation can erase the value of the 1000 USD significantly after 20 years. If inflation will reduce the purchasing power of the dollar currency by 50% in next 20 years, then 1000 USD will value only 500 USD after 20 years in terms of the articles and services it can buy. Thus the investment value can reduce significantly over the time because of inflation.
That’s why higher inflation increases the selling of the bonds in the market and reduces the demand, thus the bond price falls in higher inflationary environment. Higher inflation also leads to higher interest rate which also reduces the bond price in the market.
Even risk relates to risks arising from any other source except financial markets or financial condition of a country. It mainly refers to the unexpected risks because of natural disasters or calamities, corporate merger and acquisitions, any political event, any terrorist attacks which cause huge unexpected losses in the debt securities or bond investments. Like a natural disaster can affect an insurance company’s liquidity position significantly and reduce its credibility to pay the interest and principal on time.
Sovereign risk refers to the risk arising from the government’s unwillingness or inability to meet its loan or debt interest or principal obligations. Existence of sovereign risk wants the creditor to check the sovereign risk quality of the country to lend or invest any money in the foreign country. If the government policies are not supportive, then it is very much risky to invest such countries.
Sovereign risk can increase because of
Sovereign risk possesses high risk for cross-border investments and it has to be calculated properly before doing any such investments.