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Bond-related risks (Interest rate risk (Will tend to increase the longer…
Bond-related risks
Interest rate risk
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When external market interest rates rise, bond prices fall because investors will switch to alternative products
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If the rates in the market rise above the bond rate, the corporate bond rates become less competitive and thus the market price of bonds will fall
If external interest rates fall, the corporate bonds become more competitive and more attractive to investors so the bond prices will tend to rise
Default risk
If bond issuers either fail to repay capital in full at maturity or fail to make coupon payments as and when they fall due or perhaps try to reach arrange to pay a lower amount, they will be in default
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If a company does go into liquidation, the bondholder may receive absolutely nothing if the company has no assets and only huge liabilities
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All investors should ensure they are aware of the credit reference agencies rating relating to specific bond issues in order to assess credit and default risk
Inflation
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The longer the term of the bond, the greater the risk that inflation may erode the real value of both the coupon and redemption proceeds
If there were to be hyperinflation this could reduce significantly the value of the coupons and redemption proceeds
If there is deflation this will increase the value of the coupon payments and final redemption proceeds
Issue specific risks
An investor should read and understand the relevant bond prospectus thoroughly including full terms and conditions
Some corporate bonds will have call facilities allowing the issuer to repay the bond early which may not be what the investor wants. his could be problematic for the investor who is expecting a specific return of capital at maturity and payment of coupons up to maturity.
As the callable date approaches, care needs to be taken not to buy such a bond OTC or in the secondary market. This is because an investor might mistakenly believe they have a margin. If nothing else, there may be the cost of commission, and the investor may have to buy
a lower-rated bond to obtain a similar coupon, or alternatively accept a lower coupon from the same issuer in the event that the bond is called
Market risk
An investor will buy bonds either directly in the primary tamrekt or in the secondary market at a specific price and yield
Prices will fluctuate from day to day and in the event that an investor has to sell early because of unforeseen circumstances, they will have to accept the prevailing market price possibly incurring and loss of coupons
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Event risk
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For example where the corporate issuer of the bond becomes the target of a leveraged buy out thus increasing the risk of lending any money to that company
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Opportunity cost
Particularly pertinent to long term bonds as an investors capital is committed for a considerable period of time
There is a possibility that a better opportunity could arise where far better returns could be achieved
The investor cannot take advantage of this opportunity because the money is already tied up in the corporate bond
Maturity risk
A bond that has a redemption date many years into the future will have a higher coupon than a short dated bond issued by the same company
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Risk mitigation
In order to mitigate risk potential bond holders can check bond activity which will be an indicator of its liquidity
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Diversification
If funds allow, investors should try to buy a range of bonds with different maturity dates and coupon rates ensuring a diversified bond portfolio that includes gilts corporate bonds
Buying bonds in a relatively new company carries a far higher risk than investing in an established company
Earning potential
If the company does particularly well, the holder only receives their fixed rate of interest whereas with equities an investor may do extremely well as returns are not restricted to a single fixed coupon rate
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Rating downgrades
Where either the bond itself or the issuer receives a rating downgrade, this will negatively affect the price of that bond. This could be good for new buyers as the yield will increase but would be bad for existing bond holders