Question

Why are bonds somewhat risky to buy, even though they make predetermined payments based on a fixed rate of interest?

Short answer

Bonds, despite offering predetermined payments and fixed interest rates, carry various risks, making them somewhat risky investments. These risks include interest rate risk, credit risk, reinvestment risk, inflation risk, and liquidity risk. Interest rate risk refers to the fluctuation of bond prices due to changes in market interest rates. Credit risk involves the possibility of the borrower defaulting on interest payments or principal repayment. Reinvestment risk arises when interest payments need to be reinvested at a lower rate than the bond's original coupon rate. Inflation risk is the potential erosion of the purchasing power of the bond's fixed interest payments due to increasing general price levels. Lastly, liquidity risk refers to the difficulty of selling a bond easily and quickly at a fair price, which may lead to losses or missed opportunities for the bondholder.

Step-by-step solution

Understanding Bonds

A bond is a fixed income investment in which an investor loans money to an entity (typically a corporation or government) which borrows the funds for a defined period at a fixed interest rate, or the coupon rate. In return, the bondholder receives interest payments and, eventually, the return of the principal amount at the bond's maturity date.

Predetermined Payments

The predetermined payments, or the interest, are paid by the borrower to the bondholder at regular intervals, usually semi-annually. The interest payment is based on the coupon rate and the principal amount of the bond.

Interest Rate Risk

One major risk associated with bonds is interest rate risk. When market interest rates rise, the price of existing bonds with fixed interest rates usually decreases. This is because new bonds issued will have higher rates, making existing bonds with lower rates less attractive and consequently decreasing their value. The inverse occurs when market interest rates fall. An investor who buys a bond and intends to hold it until maturity may not experience a loss due to interest rate risk but may be subject to opportunity cost if rates rise significantly.

Credit Risk

Another risk associated with bonds is credit risk. This is the risk that the borrower will default on their interest payments or principal repayment, causing the bondholder to suffer a loss. Credit risk is usually higher for bonds issued by companies, especially those with lower credit ratings. Government bonds tend to have lower credit risk but may still carry some risk, depending on the financial stability and creditworthiness of the issuing government.

Reinvestment Risk

Reinvestment risk arises when a bondholder has to reinvest the periodic interest payments received from a bond at a lower interest rate than the bond's coupon rate. For example, if an investor receives interest payments from a bond and market interest rates have declined, they may be forced to reinvest their interest income at a lower rate than the bond's original coupon rate. This can lead to lower overall returns for the investor.

Inflation Risk

Inflation risk is the possibility that the purchasing power of the bond's fixed interest payments will erode over time due to an increase in the general price level of goods and services. This risk is more pronounced for long-term bonds, as the impact of inflation compounds over time, potentially reducing the real value of the interest and principal payments.

Liquidity Risk

Liquidity risk is the likelihood that an investor won't be able to sell a bond easily and quickly at a fair price. Some bonds may have lower trading volumes or fewer interested buyers, making it difficult for an investor to sell the bond when needed or resulting in the need to sell at a discounted price. This may cause the bondholder to suffer a loss or miss out on other investment opportunities. In summary, bonds can be somewhat risky investments due to various factors such as interest rate risk, credit risk, reinvestment risk, inflation risk, and liquidity risk. While bonds offer predetermined payments with fixed interest rates, these risks can affect the bond's value and the overall return of the investment.