Learn about Bonds: What are the risks ?

What are the risks ?

All investments involve risk, and bonds are no exception. Before we go on to consider the relative risk of the fixed income and equity asset classes, it is worth taking a moment to consider the different types of risk that an investor might face. Investment risk can be broken down into roughly four categories as follows:

  • Risk of default: The risk that the investee may be unable to return all or some of the money advanced to him. In the bond markets this is known as a default. The equivalent in the equity market would be a company going bust and ceasing to trade.  
  • Market risk: The investor buys an asset at price "X". This price will then fluctuate from day to day according to the balance of supply and demand in the market, creating a paper profit or loss. Thus, if the investor needs to sell the asset to raise funds, he faces a risk of capital loss.   
  • Issue-specific risk. Many bonds are issued with imbedded features such as "calls", which enable the issuer to repay the debt ahead of schedule. This can be disadvantageous to the holder. However, such features are clearly laid out in the bond prospectus, so careful investors can either avoid such issues, or make contingency plans.
  • Event and other risks: This encompasses a variety of "operational" hazards such as brokerage charges, slippage or a shift to an unfavourable or punitive tax treatment. These types of risk can be reduced through careful planning and monitoring. Next we have "event risk". An example of this would be the issuer of the bond becoming the target of a leveraged buyout, increasing the degree of risk of lending money to the company. Finally, we add to this list the risk of inflation, which can devalue the asset or portfolio over time.

 


Bonds vs equities

A common reaction to the subject of bonds from private investors is "lending money to companies.... sounds risky to me". Yet, these same investors will happily buy shares in medium, small and start-up companies which pay no dividend and carry a real and present threat of total loss. Why would this be so? The answer is, I suspect, that the fanfare of potential great rewards from growth stocks drowns out the fear of capital loss. In the bond markets, where the upside may be more limited, a sober reality sets in and greed and fear strike more of balance.

So much for the emotion. How about the facts? These paint a different picture. Looking first at the risk of default, bonds emerge as the clear winner. For Gilts, the risk of default can be assumed to be nil, and the quality of the credit should be viewed as superior to that offered by a bank deposit.  When buying senior bonds issued by banks, the credit quality should be viewed as the same as that of a bank deposit. Corporate bonds typically carry more risk. However, in the event of a company being placed into liquidation, bonds holders rank high amongst the creditors and will be paid out ahead of the equity shareholders.

We will now turn to our second category, namely market risk.  Again, fixed income interest instruments emerge the winner. Bonds differ from equities in an important aspect. In order to realise your profit (or loss) on an equity, you must sell the instrument back to the market – at whatever price the market happens to be quoting. But with the vast majority of bonds, the redemption date and amount are fixed in advance, so reducing your reliance on fickle market sentiment or changing liquidity. This is a vital advantage for people who have excess cash to invest now but who know that, at a certain point in the future, they will want to spend it. Whether it is planning ahead for school or college fees, retirement, moving house or starting a new enterprise, bonds will keep your money growing. And you won’t run the risk that the stock market will enter one of its unpredictable bear phases at the very time you need to convert your investments back into cash.

And what about market risk prior to the redemption date? There is risk associated with this factor. The secondary market in bonds will be affected by future interest rate expectations and the perceived credit quality of the issuer. Longer-dated bonds typically exhibit greater price volatility than short dated issues.

We have examined the price history of three bonds over a 5 year period (the 5 years to Dec 2006). For comparison we show the price range of the equity of the same company. The period is a good one to study, given that it covers both a bear and bull phase of the stock market.

The range shown gives an indication of volatility, but this is of course a double edged sword. You can gain as well as lose! Perhaps a better illustration is the "worst case scenario" of maximum drawdown. This illustrates the loss an investor might face if he bought at the highest point and sold at the lowest subsequent low (which can well happen!).  

 

Issuer

Bond
5-yr high/low
% from high
Max drawdown
Price at end of period
ICI
7.625% Aug 2007 109-101 7.9% 7.9% 101.15
Marks & Spencer
6.375% Nov 2011 111.5- 90 19.3% 19.3% 102.4
Toyota Motor Credit
6.25% Dec 2006 109.8-100.75 8.2% 8.2% 100.75

 

Equity

Class
5-yr high/low
% from high
Max drawdown
Price at end of period
ICI
Ordinary shares 452-100p 78% 71% 452p
Marks & Spencer
Ordinary shares 717-250p 65% 39% 717p
Toyota (Yen)
Ordinary shares Y7960-2466 69% 48% Y7960


The tables show that these equities have traded wide ranges over the past five years. This has been, on balance, to the benefit of investors. However, the maximum drawdown shows that the equities have provided a far rockier ride.  The bonds have proved less volatile.


Frequently asked questions

Are bonds more, or less risky than equities? It is fair to say that bonds are less risky than equities. Bond holders are senior creditors in the event of a company defaulting or going bankrupt. This means that they will generally receive some or even all of their money back in the event of liquidation. Price volatility in bonds is generally lower than that seen in equities. Risk adverse investors should restrict themselves to investment grade bonds and run a diversified portfolio. 

So are some bond more risky than others? Yes. Some issuers are more credit worthy than others. For more on this subject see the article "Credit rating explained". Also consider that the longer the bond, the more you are a hostage to the future movement of interest rates and inflation.

What happens if the issuer of the bonds goes bust? In this event the bond holder may be unable to pay the coupons or the principle. However, the bond holders will have at least some priority over the assets of the issuer, ahead of the holders of ordinary shares. It is worth bearing in mind that the incidence of this event amongst investment grade bonds is very low.

Are there any other risks that I should be aware of? Inflation is a major risk. Over longer periods of time this may errode the return of a bond portfolio, causing the value to fall in real terms. 

Please note, the content on this section of the website is provided for educational purposes. Examples shown of prices, yields and credit ratings may have changed since the time of publication.  

Stockcube Research, March 2010