Investing in debt securities is generally considered less risky than investing in equity securities, but bondholders still face a number of risks. These risks include credit risk, interest rate risk, inflation risk, liquidity risk, reinvestment risk, and call risk. A change in a bond’s risk will affect its required rate of return and its price. The required rate of return can be thought of as the yield to maturity required by an investor. Riskier bonds typically have higher yields to maturity, reflecting the higher required rate of return.
8.1 Credit Risk
Credit risk, sometimes referred to as default risk, is the risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal. Debt securities represent legal obligations, but the issuer may face financial hardship and consequently not have the money available to make the promised interest and/ or principal payments. In this case, bondholders may lose a substantial amount of their invested capital.
It is important to note that credit risk can affect bondholders even when the company does not actually default on its payments. For example, if market participants suspect that a particular bond issuer will not be able to make its promised bond payments because of adverse business or general economic conditions, the probability of future default will increase and the bond price will likely fall in the market. Consequently, investors holding that particular bond will be exposed to a price decline and a potential loss of money if they want to sell the bond.
8.1.1 Credit Rating
Investors may be able to assess the credit risk of a bond by reviewing its credit rating. Independent credit rating agencies assess the credit quality of particular bonds and assign them ratings based on the creditworthiness of the issuer. Exhibit 3 presents the credit ratings systems of Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings.
Bonds are classified based on credit risk as investment-grade bonds (those in the shaded area of Exhibit 3) or non-investment-grade bonds (those in the non-shaded area of Exhibit 3). The term investment-grade bonds comes from the fact that regulators often specify that certain investors, such as insurance companies and pension funds, must restrict their investments to or largely hold bonds with a high degree of creditworthiness (low risk of default).
Non-investment-grade bonds are commonly referred to as high-yield bonds or junk bonds. They are called junk bonds because they are less creditworthy and have a greater probability of default. Investors in these bonds prefer the term high-yield bonds, which acknowledges the higher yields (expected returns) on these bonds because of the higher level of risk. Recall that the riskier the borrower—or the less certain the borrower’s apparent ability to repay the loan—the higher the level of interest demanded by the lender.
Although both individual and institutional investors tend to own investment-grade bonds, investors with a willingness to take on greater risk in exchange for higher expected returns dominate the high-yield bond market.
Exhibit 3 Rating Systems Used by Major Credit Rating Agencies
Credit rating agencies assign a bond rating at the time of issue, but they also review the rating and may change a bond’s credit rating over time depending on the issuer’s perceived creditworthiness. An improvement in credit rating is referred to as an upgrade, and a reduction in credit rating is referred to as a downgrade. A high credit rating gives a bond issuer two major benefits: the ability to issue debt securities at a lower interest rate and the ability to access a larger pool of investors. The larger pool of investors will include institutional investors that must hold significant portions of their investment assets in investment-grade bonds.
8.1.2 Credit Spreads
US Treasuries and government bonds of some developed and emerging countries are considered very safe securities that carry minimal default risk. Consequently, relative to these government bonds, yields on other bonds are typically higher. Investors commonly refer to the difference between a risky bond’s yield to maturity and the yield to maturity on a government bond with the same maturity as the risky bond’s credit spread. The credit spread tells the investor how much extra yield is being offered for investing in a bond that has a higher probability of default. Example 7 shows the credit spread for a bond issue by Caterpillar Inc.
EXAMPLE 7. CREDIT SPREADS
Caterpillar, a US company, has a bond outstanding with a maturity date of 27 May 2041. The bond’s coupon rate is 5.2%. On 13 April 2012, the bond was trading at a price of $1,185.32, representing a yield to maturity of 4.10%. The bond has approximately 29 years remaining until maturity as of 13 April 2012. On that same date, 30-year Treasury bonds are yielding 3.22%.
The bond’s credit spread over a 30-year Treasury is 4.10% – 3.22% = 0.88%, or 88 bps. The extra yield, or credit spread, being offered by the Caterpillar bond serves as compensation to the investor for taking a higher risk relative to the Treasury bond.
Higher-risk bonds, such as junk bonds, trade at wider credit spreads because of their higher default risk. Similarly, lower-risk bonds trade at narrower credit spreads relative to high-risk bonds. Credit spreads enable investors to compare yield differences across bonds of different credit quality. If a bond is perceived to have become more risky, its price will fall and its yield will rise, which will likely result in a widening of the bond’s credit spread relative to a government bond with the same maturity. Similarly, a bond perceived to have experienced an improvement in credit quality will see its price rise and its yield fall, likely resulting in a narrower credit spread relative to a comparable government bond.
8.2 Interest Rate Risk
Interest rate risk is the risk that interest rates will change. Interest rate risk usually refers to the risk associated with decreases in bond prices resulting from increases in interest rates. This risk is particularly relevant to fixed-rate bonds and zero-coupon bonds. Bond prices and interest rates are inversely related; that is, bond prices increase as interest rates decrease and bond prices decrease as interest rates increase. Example 4, in the zero-coupon bond section, illustrates the effect of an interest rate change on a zero-coupon bond.
Prices of zero-coupon and fixed-rate bonds can decline significantly in an environment of rising interest rates. However, because coupon rates on floating-rate bonds are reset to current market interest rates at each payment date, floating-rate bonds exhibit less interest rate risk with respect to rising interest rates. But a floating-rate bond may exhibit interest rate risk in an environment of declining interest rates because bondholders receive less coupon income when the bond’s coupon rate is reset to a lower rate.
8.3 Inflation Risk
Nearly all debt securities expose investors to inflation risk because the promised interest payments and final principal payment from most debt securities are nominal amounts—that is, the amounts do not change with inflation. Unfortunately, as inflation makes products and services more expensive over time, the purchasing power of the coupon payments and the final principal payment on most bonds declines.
Floating-rate bonds partially protect against inflation because the coupon rate adjusts. They provide no protection, however, against the loss of purchasing power of the principal payment. Investors who are concerned about inflation and want protection against it may prefer to invest in inflation-linked bonds, which adjust the principal (par) value for inflation. Because the coupon payment is based on the par value, the coupon payment also changes with inflation.
8.4 Other Risks
In addition to credit risk, interest rate risk, and inflation risk, investors in debt securities also face a number of other risks, including liquidity risk, reinvestment risk, and call risk.
Liquidity risk refers to the risk of being unable to sell a bond prior to the maturity date without having to accept a significant discount to market value. Bonds that do not trade very frequently exhibit high liquidity risk. Investors who want to sell their relatively illiquid bonds face higher liquidity risk than investors in bonds that trade more frequently.
Reinvestment risk refers to the fact that in a period of falling interest rates, the coupon payments received during the life of a bond and/or the principal payment received from a bond that is called early must be reinvested at a lower interest rate than the bond’s original coupon rate. If market interest rates fall after a bond is issued, bondholders will most likely have to reinvest the income received on the bond (the coupon payment) at the current lower interest rates.
Call risk, sometimes referred to as prepayment risk, refers to the risk that the issuer will buy back (redeem or call) the bond issue prior to maturity through the exercise of a call provision. If interest rates fall, issuers may exercise the call provision, so bondholders will have to reinvest the proceeds in bonds offering lower coupon rates. Callable bonds, and most mortgage-backed securities based on loans that allow the borrowers to make loan prepayments in advance of their maturity date, are subject to prepayment risk.
How do the risks of a bond affect its price in the market? The yield to maturity on a bond is a function of its maturity and risk. In general, two bonds with the same maturity and risk should trade at prices that offer approximately the same yield to maturity. For example, two five-year bonds with the same liquidity and a BBB rating will trade at approximately equal yields to maturity.
Low-risk bonds, such as many government bonds, trade at relatively lower yields to maturity, which imply relatively higher prices. Similarly, high-risk bonds, such as junk bonds, trade at relatively higher yields to maturity, which imply relatively lower prices. Relative to secured debt, subordinated debt securities offer higher yields to maturity, which reflect their higher default risk.