Bonds. Understand the risks
When you buy a bond you want to get paid the promised interest on time and your money back at maturity. It's really that simple. Let's assume you buy a bond for £100. It has a five year maturity and it pays 5% per annum. Your expectation is that you will receive £5 interest at the end of each year and your £100 back at the end of the fifth year.
The main risks that you face are that the issuer misses or cannot pay an interest payment or that it cannot repay you at maturity.
The issuer delays or misses a payment
Maybe the issuer loses a big contract, maybe the issuer's offering becomes less competitive. It's possible that in the course of business, the issuer's ability to generate cash to make interest payments is impacted.
When this happens, it's possible that the issuer may not be able pay interest as it falls due. This situation forms part of the risk that we call "credit default" risk.
The issuer cannot pay you back at maturity
This risk is also part of "credit default" risk.
If this happens it will be because either the issuer is not able to repay because of performance or the markets may have unexpectedly closed.
The other risk is this: if you sell the bond before maturity, you may receive a price that is less than you paid for it.
Like shares, bonds go up and down in price after they are first issued in the "primary market".
If you need to sell the bond to raise cash then you may make a capital loss (or gain). The price will depend on:
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the performance of the issuer (credit default risk)
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interest rate changes (interest rate risk)
I've bought the bond to "hold-to-maturity"
If you buy a bond to hold to maturity then it doesn't matter if the price of the bond goes up or down. You're in it for the coupon payments and so long as the issuer does not default on the coupon payments or the return of your money, your expected return won't be impacted.
You plan to hold the bond for a period of time and you may need to sell it before it matures
Here, you are exposed to the market price of a bond. When you come to sell it, it may be worth less than you paid for it.
The price of the bond will depend on the performance of the issuer (if it's doing well, it may be priced higher than £100) but also the direction of interest rates. As interest rates go up, bond prices tend to fall. And when interest rates fall, bond prices go up.
This is called "interest rate risk". We look at that here ...