Understanding the risks in bond investing

Bonds are increasingly becoming popular financial instruments in Nigeria with the introduction of the FGN Savings Bond. Until that introduction, bonds were relatively out of reach for retail investors.

Many investors, especially retail investors, also think that bonds investments come with no risk compared to equity investments, especially when such bonds are issued by the federal government or other sovereign entities. That assumption or insinuation is not perfectly correct. Infact every investment activity, be it bond, equity or real estate comes with risk although the risks may differ in magnitude and severity.

In this article, we will look at risks in bond investing.

Default Risk:

As a premise for this discussion, we will take bond investing to mean a situation where the bond investor or buyer lends money to the bond issuer in exchange for periodic payment of interest and eventual repayment of the principal amount lent to the issuer at an agreed date, usually the date that the bond matures.

With that definition at the back of our mind, one would see that there is a risk that the issuer may not be able to pay the interest when due or even not be able to repay the principal at maturity. This inability or failure to pay is the risk of default. Default risk can be complete or partial. Complete default risk arises where nothing is repaid on a bond while partial default arises where a portion of the bond is repaid.

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Downgrade Risk:

Usually, before a bond issuer issues a bond or places the bond on offer, it usually obtains a rating from a recognized rating agency like Agusto. The rating adds credibility to the bond being issued.

However, after the issue, the fortunes of the issuer may change in such a way that the rating agency may change the rating assigned to the bond, either upward or downward. So, downgrade risk is the risk that a credit agency will reduce the credit rating assigned to the bond/issuer based on the issuers’ current earnings power and its ability to repay the bond.

A serious downgrade can turn an originally high-grade bond to a junk leaving the investor with a worthless piece of paper- the bond indenture.

Credit Spread Risk:

In some cases, bonds are valued in reference to a reference bond. For example, a corporate bond maturing in 10 years may be valued with reference to the 10-year FGN bond.

Depending on the difference between the bond and its reference instrument, the yield between them may be quite close but as the fundamentals of the issuer changes, the market begins to react to the changes. This reaction could lead to a narrowing or widening of the difference between the yields.

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Under normal circumstances, the market demands some compensation if the fundamentals of an issuer weakens and the compensation comes by way of increased yield which derives from a fall in bond price. The inverse relationship between bond price and interest rate implies that when the market price of a bond falls, its yield increases.

Therefore, credit spread risk is the risk that the spread over a reference rate will increase. Changes in credit spreads affect the value of a bond and can lead to losses or underperformance relative to a reference bond or benchmark. Credit spread risk is related to downgrade risk in that the higher the rating, the smaller the credit spread and vice versa.

Reinvestment Risk:

One major difference between equity investments and bond investments is that equities can be held for as long as you want unless the company gets delisted. But bonds have maturity date, being the date that you will receive your original investment back.

Unless you had planned to use the repaid amount for something its, chances are that you would like to reinvest the amount realized from a matured bond by buying another bond.

However, depending on the direction of market interest rate, you may not be able to reinvest in a bond with similar characteristics as the one that matured. If interest rate is decreasing, you will most likely reinvest in more pricy or expensive bonds with lower coupons. The risk of not finding an appropriate bond to invest in or reinvesting in a more expensive but lower coupon bond, is reinvestment risk. This risk is more predominant with investments in callable bonds.

A callable bond is a bond that grants the issuer the right to repay the bond before maturity (usually on call dates) and issuers tend to exercise this right when interest rates are falling because it gives them the opportunity to save on coupon payments and manage their balance sheet.

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Liquity Risk:

Unlike equities that are readily traded on a daily basis, bonds are not as readily traded. This happens more with corporate bonds and more so when the fortunes of the issuer weakens. There may be the likelihood that an investor holding a bond may not be able to find a buyer when he wants to sell. This risk of not being able to sell as at when needed is the liquidity risk inherent in bond investing. Note that this risk does not apply to government bonds as much as it does to corporates.

Now, when you pick up that pen to complete the forms to buy a bond, you know the risks you are up against.