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Understanding Bonds And Their Risks

10 Feb, 2023
  • Written By: Mimi Anane-Appiah

Bonds are fixed income investments which allow an investor (the holder) to lend money to a government (issuer) or another entity (issuer) for a set period of time. Bonds are described as fixed income because investment in bonds earns fixed payments over the life of the bond. Bonds are often issued by governments and corporate entities. Corporate entities issue bonds to fund existing operations, brand-new initiatives, or acquisitions. Governments sell bonds to raise money and complement their tax revenue. By purchasing a bond, you become a debtor of the organization issuing the bond.

In a bond contract, the issuer owes the holder a debt and is required, depending on the terms, to pay the bond's creditor cash flow (also known as principal) at the bond's maturity date as well as interest (also known as the coupon) over a certain period of time. Depending on the economic value that is stressed, the period and amount of cash flow given changes, giving rise to various types of bonds. The interest is typically due at predetermined intervals, such semiannually, annually, and less frequently at various times.

I. Bond Features

  • Maturity Date: The date on which the bond issuer returns the money lent to them by bond investors. Bonds have short, medium or long maturities.
  • Face Value: Principal or face amount is the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to the performance of particular assets.
  • Coupon: The coupon is the interest rate that the issuer pays to the holder. Coupon rates can be fixed or flexible. For fixed rate bonds, the coupon is fixed throughout the life of the bond. For floating rate notes, the coupon varies throughout the life of the bond. Interest can be paid at different frequencies; generally semi-annual (every 6 months) or annual.
  • Yield: The yield is the rate of return on the bond investment. Yields refer to a bond’s coupon divided by its market price. While coupon is fixed, yield is variable and depends on a bond’s price in the secondary market and other factors.
  • Price: Bond price is the present discounted value of future cash stream generated by a bond. It refers to the sum of the present values of all likely cash inflows from the bond. Bonds have two prices in the fixed income market; the bid and the ask. The maximum price a buyer will offer for a bond is called the bid price, whereas the lowest price a seller will accept is called the ask price.

II. Risks Associated With Bonds

Bonds are frequently regarded as a secure investment, especially when compared to equities, and can be a fantastic way to create income. However, holders of corporate and government bonds should be aware of any potential risks. The following are some risks associated with bonds:

  • Default Risk: The possibility that the issuer of a bond security will not be able to pay interest and/or principal on time and adhere to the terms of a bond indenture is known as credit/default risk. The likelihood of a credit or default risk depends on the issuer's creditworthiness and capacity to pay its debts. Credit rating and yield have a negative relationship. Higher yields are offered by issuers with lower credit ratings in order to offset higher credit risk, and vice versa. The value of the issuer's outstanding fixed-income instruments is impacted by changes in credit ratings.
  • Interest Rate Risk: Interest rate risk is the possibility of investment losses caused by an increase in the going rates for brand-new debt instruments. The inverse link between interest rates and bond prices is the first concept a bond buyer needs to comprehend. Bond prices increase as interest rates decrease. Bond prices, on the other hand, often decline as interest rates rise. This occurs because investors strive to lock in or capture the highest rates possible for as long as they can when interest rates are declining. To achieve this, they will purchase current bonds that offer interest rates above the going market rate. Bond prices rise as a result of this increase in demand. The link between yield and interest rate is, nonetheless, favorable.
  • ReInvesment Rate Risk: Reinvestment risk, or the risk of having to reinvest proceeds at a lesser rate than what the funds were previously earning, is another threat bond investors face. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuer.
  • Price Risk: Price risk occurs when an investor does not receive the expected price when selling a bond or other debt security in the secondary market because of a negative fluctuation in prices. Since they must rely on the security's current market price, which may be greater or lower than the price they initially paid for it, investors who want to access the security's principal amount before its maturity date should pay particular attention to this.

III. How Are Bonds Valued?

Bond valuation is a method for determining a bond's potential fair value or price. Bond valuation entails determining the face value or par value of the bond as well as the present value of the bond's future interest payments, sometimes referred to as its cash flows.vA bond's market price is determined by discounting its yield to maturity by the present value of all anticipated future interest and principal payments (i.e. rate of return).

The bond's redemption yield is determined by this relationship, and since there would otherwise be chances for arbitrage, it is expected to be close to the current market interest rate for other bonds with comparable features. Bond prices fall when market interest rates rise and vice versa because the yield and price of a bond have an inverse relationship. This approach of valuing bonds is known as mark-to-market (MTM). A portfolio that is marking-to-market could experience volatility based on market conditions.

 

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