Question

Explain liquidity risk, default risk, and taxability risk. How does each of these risks affect the yield of a bond? In you opinion, should an individual or a company stay away from one specific risk compared to the others?

Answer 1

RISK

Liquidity Risk is the risk of liquidity , which is the ability of an organisation to pay /clear any of its liabilities or convert any of its assets for cash. In case of a bond, it can be explained as the inability to sell a bond in an open market.

So Yes , liquidity risk affects the yield of a bond because if the seller of a bond is unable to sell it in an open market for the price of the bond, he or she has to sell it at a lower price.

Default Risk is a risk when an investor purchases a bond he pays money to an organisation, the organisation repays such amount after a period of time with interest. So if the organisation is unable to pay the amount due to the investor on time , it is called as default risk. Generally Default risk is highly unpredictable because we never know if the organisation we are investing will hold their part of the debt good or not.

So in short , if your payment due is defaulted, it is covered under Default risk. It also has an effect on the yield because of the doubtfulness over the payment due.

Taxability Risk is a tricky one and a very rare one as well. This risk is the end result of paying more tax than you actually had planned to do when you invested in the bond. Its common knowledge that tax rules and amendments modify from year to year. Sometimes an individual may be in a tax free bracket at the time of applying the bond and eventually end up in the tax bracket on maturity. Or the government may decide to increase the tax rates on specific investments which my affect bond.

Yes this risk also affects the yield, but you have to keep in mind that the gross (pretax) yield is mostly unaffected but however the post tax yield may change.  

HOW TO STAY AWAY FROM SUCH RISK?

In my opinion, as an individual you can easily stay away from all the three risks.

Liquidity Risk - Invest only when the market is viable , dont put yourself in a market where it may be difficult for you to redeem or sell you bond when you want to. So pick the bond that always have the most demand in the market.

Default Risk - This can be avoided if an individual prefers to invest in Government related bonds where the repayment is more or less 100% certain. Rarely the government makes defaults.

Tax Risk - There are a lost of Tax free bonds available in the market and the government rarely taxes them retrospectively

For an organisation

Liquidity Risk - Make an attractive plan and issue the bond which may encourage investors to invest in your company.

Default Risk - Dont issue bonds which you cant repay. If the project isnt viable , repayment is difficult so risks go up.

Tax Risk - Companies are rarely affected by tax risks unless there is a major overhaul of the govt policy but it can modify each bond such that it accrues interest payments in its profit earning period so it pays lower tax ( Companies usually have profit in the later stages of the bond rather than in the initial stages)