The Risks in Bond Investments
The Type of Debt Bought Can Determine What Can Go Right or Wrong
Jul 31, 2008
One of the most common types of debt available to an income investor is sovereign debt; the debt of a country’s treasury. In the United States it’s Treasuries, in the United Kingdom it’s Gilts, European Union debt is BTPs, Germany is Bunds, Japan it’s JGBs and in Canada it is Canada Bonds and so forth.
Government agencies are also common but subordinate to sovereign debt. States, provinces, counties, cities and other political subdivisions are another type of local governmental debt. Another type of common debt obligations is corporate debt.
Credit Risk in Bonds
Any country’s sovereign debt is backed by the full faith and credit of that county’s treasury. Political subdivision’s credit is measured by that entity's ability to tax and their general credit worthiness. Corporate debt is issued either as debentures, which is unsecured debt or as debt secured by an asset, such as first mortgage bonds. Corporate and often political subdivisions carry ratings by a combination of three credit rating agencies.
If a credit rating is lowered, the value of the bond decreases. The opposite is true should the credit rating be upgraded. All debt trades at a concession to sovereign debt. This concession, measured in basis points, is called the "spread over the curve." The "curve" means the yield curve. The double whammy in either scenario is that spread will increase with a downgrade or decrease with an upgrade.
Maturity Risk in Bonds
The risk to the individual investor is the interest rate to reinvest at once a bond matures. This is particularly important to people that depend on that income.
The fixed-income market ranges anywhere from over-night to thirty years plus.
If an investor buys a five year note at 5% and interest rates are higher five years hence, the investor is that much better off. The opposite is true if interest rates are lower in five years. The investor would have less income. No one has a crystal ball and knows for sure what interest rates will be. At the end of the day it is an estimate at best.
Option Risk in Corporate Bonds
People think of "puts" and "calls" in terms of equity options. Many corporate bonds have options as well. A "callable" bond means that the corporation issuing the bond can "call" them back as of a certain date. The corporation would do this in order to refinance that debt at a lower interest rate. The investor has no choice but to give up the bonds.
Some corporate bonds have "puts" attached. This means the investor can "put" the bonds or notes back to the corporation as of a certain date, such as a ten year note with a three year "put." The reason for this is so a financial institution can account for this note as a three year asset which helps them manage their asset / liability "gap" better.
Yield Curve Risk
The "yield curve" is what interest rates are from very short term to quite long term. A normal curve is called "positive" where the longer the maturity, the larger the interest rate. An "Inverted" curve is where short term interest rates are more then longer term rate are. Often, the curve is "flat;" very little difference between short term and long term interest rates.
Absent any external influence such as central bank intervention, the curve reflects an economic condition. Where an investor chooses to place their money along the yield curve is very akin to maturity risk plus certain economic assumptions added.
Income investors should carefully weigh the various risks before committing their funds.
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