What are the risks of corporate bonds?
The credit risk of a corporate bond is assessed by reputable rating agencies like Standard & Poor’s, Moody’s and Fitch Ratings. The better the rating, the less the bond’s risk of default. With that said, corporate bonds are generally considered to be more risky than government bonds. Bonds also carry other risks, such as interest rate risk, inflation risk and liquidity risk:
Credit risk
Credit risk refers to the possibility that the company issuing the bond will default on their coupons or principal repayment. Rating agencies assess the creditworthiness of bonds and bond issuers, and are looked to as authoritative sources for credit risk information. The credit risk on a corporate bond may change over the bond’s active lifespan – for example, a company’s risk of default could increase in adverse business conditions.
Interest rate risk
Interest rate risk is the chance that rising interest rates will result in a depreciation of your bond’s market price. This is because when interest rates are higher than the bond’s coupon rate, investors can earn better returns elsewhere. If this occurs, demand for the bond will likely decrease.
Inflation risk
Inflation risk refers to the potential for rising inflation to negatively affect your bond’s market price. High inflation means that the coupon amount is less valuable in terms of purchasing power. It also means that monetary authorities may raise interest rates. In a worst case scenario, if the rate of inflation rises over the coupon rate of your bond, your investment will lose money in real terms.
Liquidity risk
Liquidity risk is the possibility that the market may not have enough buyers to purchase your bond holdings quickly and at the current price. You would then risk selling the bond at lower price than what it should be worth given its coupon rate and face value.
Currency risk
Currency risk only occurs if you buy a bond that pays out in a different currency to your reference currency. If you do this, then fluctuating exchange rates may see the value of your investment drop.
Call risk
Call risk arises when the company issuing the bond has the right, but not the obligation, to repay the bond’s principal before its official expiry date. If this happens, as the bondholder, you’d lose future coupon payments. Additionally, you may not be able to reinvest the principal in an asset that pays the same level of interest.