Bond risks
Bonds are investments. Just like shares, bonds go up and down in price depending many factors that impact demand. There are risks you should consider.
The two main questions you should ask when looking at a bond are:
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how credit-worthy is the issuer/how likely is it that the issuer will not pay me? This risk is called credit default risk. This risk is specific to the issuer, see here
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how will the value of my bond change as interest rates move? This is is called interest rate risk. When interest rates move, the price of most bonds adjusts. We will look at this in more detail here
Credit default risk
Credit default risk is the risk that a borrower cannot pay you the interest it owes or it cannot pay you back on time or as promised.
When any lender lends money, it assesses how good the borrower is.
Does the borrower have the means to pay interest?
What sources of income does the borrower have? Is the borrower's income likely to go up or down? If income goes down, will this impact its ability to make interest payments? Under what circumstances might the borrower's ability to pay interest become difficult?
How will the borrower pay the money back?
It is quite common for a borrower to refinance bonds by issuing new bonds. Sometimes a borrower may refinance with another lender such as a bank or a private debt fund. Sometimes a borrower may build up cash reserves to repay a bond.
Fortunately, big borrowers are asked by investors to get "credit ratings" which are an assessment of the credit-worthiness of the borrower. The better the rating the lower the expected risk of default. See here for more details on credit ratings.
Is the UK government likely to default? It's possible but very unlikely - it could just increase taxes to pay its debts.
Suppose your bond issuer finds itself losing a major contract, its technology being made obsolete or under investigation - none of those sound good. It's possible that the company's financial performance might suffer. You may conclude that the risk of it defaulting (being unable to meet its interest payments) has increased. If lots of investors feel that way, the price will fall because the credit-default risk has increased.
Default risk can also reduce too. Suppose your bond issuer was acquired by its larger competitor. This may be perceived as credit positive - meaning that the risk of default is now less. Your bonds might go up in value.
Because there are so many investors taking different views, market pricing is usually efficient meaning that the price reflects the balance of buyers and sellers.
Interest rate risk
Interest rate risk is the risk that you face when interest rates change or when the market expects interest rates to change. All bonds face this risk. An example is the best way to explain ...
Suppose today, you buy a new issue 3 year Gilt that pays 0.5% interest per year. Interest rates suddenly need to go up to control inflation. Tomorrow, the government issues a 3 year Gilt with a 3% interest rate.
The two bonds have the same credit default risk (the government) and the same maturity. You'd naturally prefer to own the bond with the higher coupon!
The bond paying 0.5% will suffer from interest rate risk - investors will sell it and buy the new bond that pays them more. What this means is that its price will fall so that the return (the yield) is the same as the newly issued bond that pays 3%!
When interest rates go up, the price of bonds generally fall. The reverse is true too. When interest rates fall, you'd expect bond prices to increase.
But Bond prices move.
Should you care?
That depends on whether you must sell. Many investors don't need to sell and so they don't worry that a bond has gone down in price because they take the view that the company will pay them back. It's like holding equity: prices go up and down. You have to make a call. If you need the cash, you may need to sell at a loss (or a gain!)
If you sell a bond below the price you paid for it, you'll make a capital loss. But whatever the price, the interest payable is always the same - whether you paid £80, £100, or £120. Let's look at yields now.
Bond yields?
Different to the interest!
The interest rate is also known as the coupon. Here, we have a 5% interest rate (a 5% coupon).
The yield is something different.
To keep things simple, if you buy Bondco's bond at £100 and hold it to maturity, your yield will be 5%. The yield is the same as the coupon because you paid £100 and received back £100.
Suppose the bond was offered to you for £80. Intuitively, you know you will make more money because you pay £80 and get back £100. Your "yield" has gone up. The yield on a bond therefore depends on the price you pay for it. If you pay more than £100, then your yield will be below 5%.
PRICE LESS THAN PAR? > > > YIELD MORE THAN COUPON
PRICE MORE THAN PAR? > > > YIELD LESS THAN COUPON