Bonds are always lower risk than shares in the same company but do carry some of the same risks. They also have unique risks that can be used to your advantage under various economic conditions.
Risk means different things to different investors. To some it means uncertainty or possible volatility in returns and to others the possibility or odds of losing money or the chance of unwinding a position at a loss. We think it’s both. The upside
of taking risk is higher possible returns.
Two prevalent risks:
As the world adjusts to a new paradigm of higher interest rates and inflation, risks abound as the danger of a central bank induced hard economic landing rise and fall with each new data release.
Are rates to go higher and inflation to remain more entrenched, so floating rate bonds are likely to outperform? Or if a recession comes and with it the usual response of bankers to lower interest rates to stimulate (after over tightening of course),
will longer dated fixed rate bonds (the most vulnerable to the above conditions) be the ones to secure a higher longer term income stream and also see gains in their capital price?
Which issuers will be unable to survive in a higher interest rate environment? Is it worth chasing higher yields which are genuinely high for the first time in years but potentially putting your capital at risk?
Interest rate and credit risks are two of the top 10.
The complete list is as follows:
Credit or default risk - this is the risk that the bond issuer may be unable to meet the interest and/or principal repayments when due, defaulting on the bond. Generally, the higher the credit risk of the issuer, the higher
the credit margin that investors will expect in return. If perceived credit risk increases, the bond price should fall.
Sub sections of credit risk:
- Political or country risk - the risk of loss when investing in a given country caused by changes in a country’s political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction
in repatriation of profits. The Russian invasion of Ukraine showed how country risk can be very different from one place to the next. Sovereign risk is essentially the credit or default risk of a country but also results in heightened
risk of political and regulatory changes.
- Regulatory risk - the risk of regulation changes on a business or industry. This is particularly relevant for financial institutions such as banks and insurers as regulatory changes may have material changes on the value
and call risk of regulatory capital securities such as subordinated notes (Tier 2) and hybrid (Additional Tier 1) securities. The non-viability clause required in any subordinated and Tier 1 security issue is a good example of regulatory
risk.
Interest rate risk - the risk associated with an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. This mainly affects fixed rate bonds. When the expectation of interest rates is that
they will rise, fixed rate bond prices will fall, and the reverse is also true. Expectations of lower interest rates will see fixed rate bond prices rise.
Floating rate bonds are more capital stable given interest is adjusted quarterly to reflect changes in the underlying benchmark rate.
Call risk – the risk faced by a holder of a callable bond that a bond issuer will or will not call the bond at the first opportunity.
Callable bonds give companies the right, but not the obligation, to repay the bond before the final maturity date or leave it on issue for the next call date or until maturity. There can be one call date or many call dates depending on the particular
issue.
Companies will generally act in their own best interest. For example they would opt to extend maturity if it would cost them more to reissue a new bond or repay at first call if they could refinance at a lower interest rate.
Financial institutions will also weigh up reputational consequences of calling early or extending and in the past have placed a very high reliance on reputation. Some financial institution callable bonds are subject to APRA approval before being
called.
If a company decides not to call a bond when the market was otherwise expecting it to do so, the value or the price of the bond may fall.
Sub section of call risk:
Early redemption risk – the risk faced by a holder of a callable bond that a bond issuer will take advantage of the callable bond feature and redeem the issue prior to maturity. This means the bondholder will receive
payment on the value of the bond (typically at par) even if the bond was trading at a premium (over its $100 face value). In good economic times, there is also reinvestment risk in that the investor may be reinvesting in a less favourable
environment (one with a lower interest rate).
- Liquidity risk – this is the risk that a security cannot be easily sold at, or close to, its market value.
Illiquidity is heightened during extreme economic or market events, as we have seen recently. Generally, the lower the risk of the bond the easier it will be to sell at or close to its market value. Part of the premium for investing in higher risk
bonds is to compensate for lower liquidity.
Inflation risk – mainly associated with fixed rate bonds where there is a set return that may not cover inflation if it starts to spiral upwards. Inflation linked bonds directly hedge inflation risk while floating rate notes
would somewhat protect investors, with expectations of higher interest rates to combat inflation likely to increase the underlying benchmark interest rate, typically Bank Bill Swap Rate (BBSW), noting that the correlation of inflation to interest rates is not perfect.
Exchange or currency risk – arises from moves in foreign currency rates for investors buying bonds denominated in a currency other than the currency of their liabilities. Reflects that any bond price appreciation can be
entirely wiped out by unfavourable currency movements, or vice-versa.
Event risk – risk due to unforeseen events, for example a company making a large acquisition,a global pandemic or an invasion.
Counterparty Risk – is the risk to each party that the other will not live up to its contractual obligations.
For example, a typical Residential Backed Mortgage Security (RMBS) transaction would issue multiple floating rate tranches (based on BBSW) and yet many mortgage loans in the portfolio would be fixed or floating but based on the relevant bank’s lending rate.
In order to avoid any rate mismatch, the transaction will include an interest rate hedge that will ensure the mismatch is removed. Likewise for RMBS, many include loans that are supported by lender’s mortgage insurance but this protection
is only as good as the insurer.
Another example of counterparty risk would include Australian-based issuers (with no overseas operations) issuing USD dollar bonds and entering into a foreign currency swap ensuring that the amount of interest and principal over the life of the
bonds are fixed in AUD. If the provider of that hedge disappears, the issuer would suddenly become exposed to FX fluctuations.
Tax Risk - withholding tax may be charged for investors that invest outside their domestic jurisdiction. It can be overcome by providing a tax file number in Australia or completing a W8-BEN form for US investments. If the tax
law changes, there is a risk that tax would be withheld by the issuer and investors would receive less than expected. If the terms and conditions of the bonds allow for that retention, the lower payment would not constitute a default.
Structural Risk – in the case of a weak covenant structure, other creditors may be allowed to take a more senior position, pushing down the bond holder’s position in the creditor’s priority queue. For example,
an unsecured bondholder with weak covenant protection that allows the issuer to increase secured debt.
It is important for investors to understand where their investments sit in the capital structure as this directly correlates to the risk involved. Investors should frequently reassess the return they are receiving and whether this is sufficient given
ever changing market expectations of credit risk, call risk and interest rates. Moreover, they should ensure that the additional return for moving down the capital structure compensates for any additional risk.