Bond Risks You Should Be Aware Of | srei
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Bond Risks You Should Be Aware Of

There is a notion that bonds are low risk as compared to the ups and downs of stocks. This may be true but what if there something more than what meets the eye? Are there certain risks present that investors are not aware of? What we are trying to do in this article is to expose the risks that wait to steal your hard-earned profits.

We don’t need to get into how bonds work, we all know about maturity and interest rates. Like any asset class, bonds have distinct advantages and disadvantages. In the current financial climate of rising interest rates the previously not so apparent disadvantages are mounting. Rising interest rates tend to punish holders of existing bonds and further increases are probably on the cards. Contrary to popular belief, bonds are not for everyone.  You need to first understand what kind of a role these bonds will play in your portfolio. To do this the let us understand the various risks associated with these bonds.

Yield Curve Risk
Each bond reacts differently to rates depending on different factors. The Yield Curve Risk shows how sensitive your bond portfolio is to interest rate risks.

Reinvestment Risk
Bonds are called early when interest rates are below the coupon rate. The investor will have to “reinvest” back into a bond with an interest rate lower than the coupon rate. In this case the holder is subject to reinvestment risk.

Call Risk
Most bonds have a defined maturity but in some cases you have the option to ‘call’ the bond early. Your revenue stream is not 100% guaranteed because when you call these bonds these streams can be stopped.

Default Risk
Basically, default risk is the chance that the debt issuer won’t honor the agreement which means he will “default” on the loan, or in this case the bond.

Credit Spread Risk
A major part of that yield curve sensitivity is the credit spread. Credit spread risk measures the risk of an issuer defaulting on payment due to interest rates and the economic impact. Basically, it’s the risk of default risk so to speak.

Downgrade Risk
Higher rated bonds have less default risk vs. low-rated bonds. But the logic is that low-rated bonds have more reward potential. So, if your bond ETF contains high-rated bonds, then you have a lower risk associated with your fund than say a junk bond ETF (high risk).However, what if some of the bonds in your ETF get a lower rating (get downgraded)? All of a sudden, your bond ETF now has more risk. This is downgrade risk.

Liquidity Risk
The liquidity risk of a bond is the risk of not being able to sell your asset before its maturity. This makes it a little harder to lock in an early profit.

Currency Exchange Risk
When it comes to bonds in foreign currencies, the value of your revenue streams are subject to exchange rates. As currency rates fluctuate, so does the value of your payments. Therein lies the exchange rate risk.

Inflation Risk
The cash from you payment won’t have as much purchasing power in times of higher inflation. So you have risk if inflation increases, the coupons are not worth as much as they are in times of lower inflation.

Volatility Risk
Increased rate volatility will lead to increased chances that the bond will be called (or the ‘put’ option will be exercised). As volatility risk increases, callable (or putable) risk increases.

Event Risk
Factors unrelated to the structure of a bond, can increase risk.  Other than interest rates, duration, etc event risk is a type of risk that can impact the price of a bond.

Sovereign Risk
Sovereign risk is the risk of a foreign government impacting the value of the bond. These are similar to event risks.