How Risky Are Bonds?

HOW RISKY ARE BONDS? 

Last week we established that bonds are fixed interest investments that give higher returns than money market investments and individual investors or institutions that are looking for income and modest growth in the medium to long term investments would find them very attractive. However, they do carry risks.  In this article, we explore what some of these risks are and how the investor can assess these risks and be guided by them in selecting and maintaining his or her investments.  

There are two principal risks associated with buying and holding bonds:  

1. The Default risk: You don’t get your money (principal or interest) back  at the scheduled time or at all.  The company could cease payment of interest on the bond, be unable to repay the principal or seek to change the terms of the agreement in ways that are detrimental to the bondholder.  

2. The Price risk. There is a possibility that at the time the bondholder wishes to sell the bond, the price has fallen below the level at which it was bought.  This exposes the investor to a capital loss on the investment. This risk exists with most assets that an investor can purchase. For example – stocks, real estate, etc.  
 

The Default Risk 

The Default Risk is arguably the largest risk that an investor in bonds faces as it may entail the loss of his/her principal (in part or in its entirety).  For example – The Governments of Barbados and Argentina both asked bondholders to delay interest payments, reduce the interest rate and even reduce the principal outstanding on their bonds.  Even the Government of Jamaica asked holders of its Jamaican dollar bonds to accept lower interest rates and longer maturity dates in 2010 and 2012.  These scenarios are called “restructurings”.  Click here to see how we advised investors to exit Barbados investments before the default. Many Jamaican investors also held bonds issued by the Government of Venezuela or the National Oil Company – these entities defaulted by completely halting the payment of interest and principal. Investors in these bonds (have) received no interest or principal payments for a few years.   

The Price Risk 

This second risk is not unique to bonds. It is universal to all assets that an investor owns – it is the risk that the price moves below your purchase price. If the bondholder is prepared to hold the bond until maturity, the Price Risk can be avoided altogether -  provided that the issuer continues to honour their obligations with respect to the bond. Bond prices do fluctuate according to changes in market sentiment, developments that affect the issuer, and even unfolding events in neighbouring or distant countries.    

In the normal course of things, price movements can be quite moderate, fluctuating by a few percentage points upward or downward. However, they can be quite dramatic at times - especially among bonds that have lower credit ratings. Extrenal market events – recessions, elections, political upheaval – can all affect investor sentiment.  At the time of writing in 2002, some Government of Brazil bonds that were issued at par  or 100, fell to 53 as fears about the outcome of that country’s then presidential elections took hold of the market. After announcement of an agreement reached with the IMF, the price rallied to 69 before falling again. 

Rating Agencies & Risk Assessment 

To help investors assess the risks associated with buying and holding bonds, institutions known as Rating Agencies have emerged to rate these issuers and their bonds according to the level of risk that they carry. There are a number of such agencies but Standard and Poor (S&P) and Moody’s are two of the most respected for the work they do in rating international sovereign and corporate bonds. The rating agencies employ economists and analysts who try to determine the extent to which a particular issuer  (I.e. company, Government, agency etc) may or may not be able to service their Bond liabilities. When they have quantified this risk, they assign a rating to that issuer or to the bond itself, according to where the risk falls on the Agency’s rating scale. 

For example, S&P uses a system of ratings which range from AAA - its highest rating, given to issuers with an extremely strong capacity to meet their financial commitments - right down to SD or D, which are issuers that are in default. Their rating groups run in descending order as follows: AAA, AA, A, BBB, BB, B, CCC…. D. S&P has given the US Government, an AA rating; it is estimated to have a strong capacity to meets its financial obligations. For context, Trinidad is rated BBB- or has adequate capacity to meet its obligations.  Jamaica’s rating of B+ suggests that the country is more vulnerable to nonpayment but is currently able to meet its commitments, although adverse economic conditions will likely impair the country’s ability or willingness to continue to do so. 

While the ratings are widely used in the investing community as a guide to the risk associated with a particular issuer, they are not totally reliable and do not always give a complete guide as to how the market will view and price the bonds of a particular country or company. In our next article we will look a little closer at the ratings and at some of the other factors affecting the risk associated with a particular country’s bonds. 

 
First Published: August 14, 2002  

Revised: April 2020