Risks Associated with Fixed Income Securities: All You Need to Know
Every financial investment inherits some risk, and bonds are no exception. Though fixed-income instruments provide regular and predictable income to the investors, the investor may lose the principal amount and the promised income if the bond issuer moves towards bankruptcy. However, such cases are rare, and the investor can mitigate the risk by looking at the credit rating of the instrument. Therefore, investment in government bonds is considered free of risk.
There are some risks involved in fixed-income instruments that may impact the net returns earned by the investor. Interest rate risk is a significant risk in a fixed-income security. Factors including inflation, liquidity, market intervention by the central bank, foreign exchange flows, price of competing assets etc., may affect the general interest rates in the capital markets, which in turn affects the market price of the bonds, which leads to the investment risk of fixed income securities.
Risks associated with fixed-income securities:
- Interest Rate Risk: Investors can buy bonds directly from the issuer and hold them until they mature. Or they can be traded in the secondary markets. The prices of bonds in the secondary market can be higher or lower than the face value of the bond depending on the economic factors which can be affected by a change in interest rates. For example, bond prices decline if the interest rate rises and vice versa. That’s because new bonds are expected to be issued at this time with better returns, making the old bonds less attractive to investors. However, the interest rate is not a concern if an investor holds the bond until it matures.
- Call Risk: A callable bond has an option that allows the issuer to call back the bond before it matures. If the interest rate drops reasonably, the bond issuer can save money by calling back the bonds and paying the due amount to the investors. In this case, the investor’s interest payments cease, and they receive their principal amount early. Before investing in a callable bond, the investor should check the bond’s yield to maturity (YTM) and the yield to call or the yield to worst (YTW) to determine the yield in such cases.
- Reinvestment Risk: Reinvestment risk arises if the periodic income received from bonds or other fixed-income securities is reinvested after receipt at the market’s prevailing rates at the time of such receipts. If the interest rate is higher at the time of periodic interest, the reinvestment will occur at a higher rate which is beneficial to the investor. But if the interest rate is low in the market at the time of receipt of the interest, the investor would be reinvesting the interest at lower rates. But investors must remember that higher the interest rates in the market, the interest would lead to a capital loss in the instrument’s market value if the investor decides to sell it in the market. Therefore, the interest rate is the risk where interest rates may fall during the bond’s life. And if an investor decides to hold the bond till maturity, the reinvestment risk becomes high. Hence it is an essential component of bond investments.
- Credit Risk: Bonds have the risk of default; the issuer may be unable to repay the investors the principal amount and interest in case of bankruptcy. This risk is present in corporate bonds generally. On the other hand, government bonds’ credit risk is negligible because the government has a sovereign guarantee. Still, the types of credit risk in government bonds may include Downgrade Risk and Spread Risk.
- Downgrade Risk: Credit rating agencies are responsible for rating a particular company’s ability to operate and repay its debt. It is a risk for investors when the rating of a bond issuer is lowered after they have invested in the bond. As a result, the bondholders face a fall in the price of their bonds since the cost of funds for the company increases in the market.
- Spread Risk or Basis Risk: The bond spread or yield spread is the difference in the yield of two bonds. The investors use this as an indication of the relative pricing or the valuation of the bond. Corporate or non Government bonds pay a spread over comparable Government securities to compensate investors for the higher risk. The spread changes dynamically depending on the market conditions and the company’s performance. Poor performance means the company may face cash flow issues and be unable to meet its obligation of interest payment and redemption payments, which results in the company’s debt getting very costly. The spread over comparable Government securities may change, keeping in mind the possible default of the company. And in a strict liquidity situation, or when the market conditions are bad, the risk appetite drops in the market and the spread increases. The spread charged for higher-rated papers is generally lower than the lower-rated papers in the market.
- Default Risk: It is the possibility that the bond issuer might fail to repay the fixed interest and the principal amount. This risk can be measured by checking a company’s credit rating, and investors must check it before investing.
- Liquidity Risk: It is a risk when an investor might not be able to buy or sell investments quickly at an expected price. A liquid bond has an active market where investors actively trade in a particular type of bond. For example, Treasury bonds or more significant issues by large corporations are generally liquid. Still, some bonds, such as municipal bonds, are not very liquid, and the investor may face problems while selling those before maturity.
- Exchange Rate Risk: This kind of risk exists in bonds issued in foreign currency. When the issuer of such bonds has to pay back the dues, the company has to shell out local currency to buy foreign currency to pay back the amount. The company’s cost will increase if the domestic currency depreciates against the foreign currency. For example, Masala Bonds issued by Indian entities expose the investors to the exchange rate risk because the Rupee amount is fixed. The foreign entity investors would get Indian Rupees (INR) and have to convert INR into their currency. Typically, foreign currency-denominated bonds have exchange rate risk, and the investors must consider it.
- Inflation Risk: Inflation risk concerns investors highly dependent on their bond income. Because if the rate of inflation rise, the purchasing power will decrease since the rate of returns in bonds is fixed. A fixed-rate bond does not consider such changing scenarios; however, a floating-rate bond can take care of such changes since the new interest rate would be in sync with the market rate. Therefore, investors must prefer floating-rate or inflation-indexed bonds to save them from the inflation risk when the inflation rate is expected to increase.
- Volatility Risk: This kind of risk affects the bonds with embedded options. The pricing of an embedded option considers the volatility level to price the same.
- Political or Legal Risk: Bonds with tax exemption include this risk. Tax-free bonds can be taxable in some cases if there is a change in government policies that can impact the prices of the bonds.
- Event Risk: Unplanned events lead to a drop in investment value. In cases like Covid 19 pandemic, the tourism industry was severely affected, and the companies associated with tourism failed to repay their dues.
Frequently Asked Questions (FAQs)
What are some of the risks associated with fixed-income securities?
Factors including inflation, liquidity, market intervention by the central bank, foreign exchange flows, price of competing assets etc., may affect the general interest rates in the market, which in turn affects the market price of the bonds, which leads to the investment risk of fixed income securities.
How to mitigate the risk of fixed-income securities?
An investor can mitigate the risk of fixed-income securities by using interest rate derivatives, credit derivatives, and currency derivatives.
Are fixed-income securities safer than equity?
Fixed-income securities are considered safer than equity as the risks are less in fixed-income securities, but the investor must check the potential risks before investing.