Investing in fixed-income securities, such as corporate bonds, is generally considered to carry less risk than investing in equity securities, or stocks.
Although a debate about the above proposition is the subject for another day (or two), there are several different forms of risk associated with corporate bonds that all investors should appreciate. Today we discuss five of the most important forms of risk.
The most significant risk is interest-rate risk. An increase in prevailing interest rates causes the price of bonds to decline, while a decrease in rates will lead to an increase in bond prices. Investors who plan to hold their bonds until maturity need not be concerned about this risk. More active traders, however, must recognize that higher interest rates will cause a capital loss.
Credit risk is an important consideration for investors in corporate bonds. Credit risk refers to the risk that the corporation may default on its obligations with respect to the regular payment of interest and even of the principal of the bond. Ratings from organizations such as Standard & Poor’s and Moody’s Investors Service can be helpful in determining the extent of credit risk. Lower-rated bonds, particularly junk bonds (those with a rating of triple-B-minus or lower), carry greater risk of default.
The risk that the interest payments received by the bondholder may be reinvested at a lower rate than expected is known as reinvestment risk. Bondholders estimating their potential returns assume that the coupon payments will be reinvested in other securities at a certain anticipated rate. Should yields or returns in alternative investment vehicles decline in the interim, the investor will achieve a lower total return on the initial investment than was originally expected.
Because some bonds may be called, or retired, before their maturity date, such bonds carry call risk. For the bondholder, an early call of the bond can be a negative outcome because bonds are most likely to be called when interest rates have declined, exposing the investor to the reinvestment rate discussed above. In addition, the price-appreciation component of the bond’s total return is apt to be lower than that of a comparable callable bond because the credit may not appreciate above the price at which the corporation might call the bond.
Fixed-income investors fear one thing more than anything else: inflation. Inflation risk, also known as purchasing-power risk, refers to the risk that inflationary conditions will reduce the true value, or purchasing power, of the cash flows generated by the bond. A bond purchased in anticipation of a 5% yield while inflation is running at 2% becomes significantly less valuable when inflation rises to 5% or higher.