Question

Question 1 Even though bonds are debt obligations, investing in them involves risk. Identify and discuss the various sources of risk associated with holding bonds? What service is available to aid the buyers of debt instruments in selecting a particular bond? (25 marks)

Answer 1

Various sources risk associated with holding bonds

Interest Rate Risk

Rising interest rates are a key risk for bond investors. Generally, rising interest rates will result in falling bond prices, reflecting the ability of investors to obtain an attractive rate of interest on their money elsewhere. Lower bond prices mean higher yields or returns available on bonds. Conversely, falling interest rates will result in rising bond prices, and falling yields.

Credit Risk

This is the risk that an issuer will be unable to make interest or principal payments when they are due, and therefore default. Rating agencies such as Moody’s, Standard & Poor's etc. assess the credit worthiness of issuers and assign a credit rating based on their ability to repay its obligations. Fixed income investors should examine the ratings of an issuer in order to establish the credit risk of a bond. Ratings range from AAA to D. Bonds with a ratings at or near AAA are considered very likely to be repaid, while bonds with a rating of D are considered to be more likely to default, and thus are considered more speculative and subject to more price volatility.

Inflation Risk

Inflation reduces the purchasing power of a bond’s future coupon and principal. mostly bonds involves fixed coupon payment, they are particularly vulnerable when inflation rises. Inflation may lead to higher interest rates which is negative for bond prices. Inflation Linked Bonds are structured to protect investors from the risk of inflation.

Reinvestment Risk

When interest rates are declining, investors may have to reinvest their coupon income and their principal at maturity at lower prevailing rates.

Liquidity Risk

This is the risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value. To reduce this risk, investors may wish to opt for bonds that are part of a large issue size and also most recently issued.

Question 2 - Service available to aid buyer of debt instrument before buying bond

Fixed income investors has many ways available to check whether a particular bond issue is worth investing.

- Check credit worthiness of bond issuer which investor can come to know about credit rating assigned to issuer and particular issue and also from financial statements if issuer has defaulted in payment of interest or principal on any issue or not

- Consider your liquidity requirement before investing in corporate bonds and match your investment horizon with the bond’s maturity period, which is generally 5-10 years so invest in bond with the required maturity.

- Investors should avoid complex bonds say for e.g. which has options embedded on it as it will expose investors to additional risks.

- Ratings do not account for all the risks associated with bonds. New risks could arise after investors have purchased the bond.For example, if an issuer decides to go for acquisition or any other restructuring, the debt burden on the issuer will increase. This will affect the issuer’s ability to service the existing bond liability, thereby increasing the risk profile of the bond. In some cases, rating agencies may be late in updating the company’s credit profile.