Understanding the risks of investing with bonds
As with all instruments, investing in bonds carry risk and it is important to understand these before you dive into the asset class. For the purpose of this series, we consider risks relate to short-term government bonds and bills (basically a short-term version of a government bond with special characteristics as described at the bottom of this section). They are often termed “risk-less” as a default is considered largely inconceivable, but that doesn’t mean there is no risk in buying even government bonds. Some of the risks goes across bond types, while other types of bonds may also contain other risks.
Credit risk: The credit risk is simply the risk that the bond issuer fails an interest rate payment or to redeem the bond at face value at maturity. There is no real credit risk for sovereign debt that is issued in the currency of the sovereign. (Important to note the theoretical exception of all EU countries in the Monetary Union, especially the non-core, or “peripheral” Eurozone countries like Italy and Greece, as discussed below, as EU countries in the monetary union don’t have their own central bank and are in theory more at risk than debt issued directly by the EU itself.) There is a far more significant credit risk for countries issuing debt in a currency other than their own, for example in emerging markets, and for company-issued debt/bonds. Credit risk for companies is of considerable importance and can be considered very low or very high, depending on the strength of the company balance sheet in question. Yield levels relative to the lowest risk debt in a given currency usually reflect the level of credit risk for a company or country. There is also seniority to consider, as not only are debt holders paid in the event of a bankruptcy and liquidation before equity holders, but companies may have two or more levels of seniority in their debt structure, under which the most senior debt is paid first before more junior tranches of debt.
Interest rate risk: This is the risk that the interest rate rises after the purchase of the bond or bill and the market value of the bond falls, which could result in a capital loss if sold. For example, if you buy a German government bond with 1-year left until maturity at a yield of 3.00% and the 1-year German yield rises another 2% over the next three months, your bond would be worth about 0.7% less as a buyer can only be found for that bond if it yields an annualized 5% until the maturity date, assuming yields are the same for 9-months and 1-year. If held to maturity, the bond would still be redeemed at par, or 100% of the face value, but you would have earned more had you waited to buy the 1-year-to-maturity bond at the higher interest rate.
The longer the maturity, the more the market value is affected by interest rate risk. The opposite is the case if interest rates fall after you purchase a bond, which benefits the value of your position between the time of purchase and the maturity date and offers the opportunity to take profit and invest the funds elsewhere. Given that as of this writing in early March 2023, the highest yields available are at the short-end of the yield curve (with maturities of less than two years), most will want to lock in these yields rather than taking risks that yields continue to rise, especially longer yields. Of course, if longer yields collapse, for example because the world suddenly careens into a recession and disinflation investors would have missed out on the strong rebound in bond prices as yields fall, with the best returns for the longest bonds.
Inflation risk: This is the risk that inflation rises and impacts the real return of the bond investment, which is the return less the inflation rate. With inflation running very hot over the last year and more, most real returns on bonds have been negative, though if inflation falls back sufficiently in the coming six months, bonds’ real returns may soon return to positive territory (Current medium and longer term inflation expectations are lower than bond yields, but there is a risk that inflation stays high).. If inflation rises after the date of purchase, the real return of the bond will fall.
Liquidity risk: This is the risk that it is difficult and/or expensive to find a buyer of the bond an investor holds. This is mostly a non-issue for extremely liquid government bonds and bills, but becomes a more significant issue for riskier bonds and illiquid bonds that rarely trade. The bond’s liquidity risk is generally reflected in the width of the bid-offer spread when trading the bond, especially if you both buy and eventually sell the bond position rather than holding to maturity.
Currency risk: Currency risk is entirely avoidable for investors sticking to bonds issued in their own currency, but it can be a very significant two-way risk when buying bonds in another currency. Currency fluctuations will often prove far more volatile than the return on a bond, so currency risk should generally be avoided unless the investor has a view on the currency of the bond – not the intention here. Yes, currency exposure can be hedged in the currency market, and rather cheaply if the yields are similar between the home currency and the currency of the bond of interest, but can be very expensive when the yield in the currency of the target bond is significantly higher. As of this writing, for example, a Japanese investor buying a US treasury will lock in a slightly negative return on 1-year US treasuries (the generic term for US debt) in JPY terms if hedging the entire currency exposure and holding the treasury until maturity.
Call risk: Some bonds (mostly corporate bonds, but some floating rate bonds issued by governments have callable and/or “sinkable” features under which at regularly scheduled times, the bond issuer can call away the bond at par for callable bonds or buy it back at prevailing market prices if it is sinkable.