Fixed Income Security Characteristics

There are a number of risks associated with investing in bonds. The investor can minimize or increase his exposure to certain risks by investing in bonds with properties designed to minimize or accentuate certain risks. An investor who wishes to minimize his exposure to interest rate risk may invest in a bond with a relatively short maturity, high coupon payments, or even adjustable coupon payments. The more frequent and less constrained the coupon payments are, the lower the interest rate risk of the bond. An investor who wishes to increase his exposure to interest rate risk may choose to purchase securities with a longer time to maturity and lower coupon payments. He may increase his interest rate risk by purchasing zero coupon bonds, which pay no interest and have a single repayment of principal at maturity. A review of the major risks associated with bond investing follows. Please keep in mind that many investors have benefited by consciously taking on calculated risks in their bond portfolio.

Interest Rate Risk

Interest rate risk is often the major factor influencing a bond's market price and total return. The market prices of most bonds move in the opposite direction of a change in interest rates. If the general consensus among bond investors is that the rate of inflation will increase in the future, lowering the purchasing power of the dollar, then the investor will demand a higher return for investing in a bond. The result being that newly issued bonds will pay higher interest rates to compensate the investor for this expected loss of purchasing power, and the price on bonds currently trading in the market will decrease, which effectively increases the return to the prospective purchaser of the bond without changing the coupon payment. Interest rate risk increases for bonds with longer maturities and lower coupon payments, and decreases for bonds with shorter maturities and higher coupon payments.

Reinvestment Risk

Reinvestment risk is related to interest rate risk, but has the opposite effect on a bond's performance. Reinvestment risk refers to the risk that the rate at which coupon and principal cash flows from a bond are reinvested will be lower than the expected rate in effect when the bond was purchased. If expected interest rates decrease during the holding period of a bond, the value of the coupon increases, if it is paid at a fixed rate, while the reinvestment value of the coupon flows decreases, due to the lower market rates earned on the reinvested coupon. Reinvestment risk increases for bonds with longer maturities and higher coupon payments, and decreases for bonds with shorter maturities and lower coupon rates.

Credit Risk

Credit risk is the risk that the issuer of a bond will be unable to make the coupon and principal payments specified for a given bond. This risk is the risk that most investors focus on when purchasing bonds, but it usually has less of an effect on returns than some of the other risks, namely interest rate risk or call risk. Credit risk is usually quantified by comparing a bond's yield to that of a bond with a similar maturity and cash flows but with negligible credit risk, i.e., a Treasury security. Credit risk is evaluated by major bond rating agencies, Standard & Poor's, Moody's, Duff & Phelps, Fitch, etc. As the credit risk of a bond increases, any changes to that perceived credit risk tend to have an increased impact on a bond's price. The credit risk of high yield, or junk bonds, is significant and therefore a change in the credit quality of an issuer of high yield bonds will be apt to have a significant impact on the bonds of that issuer.

Call Risk

Many bonds have call features as part of their structures, and these call features represent another risk to the bondholder. A bond with a call feature can be redeemed by the issuer prior to maturity at a specified price. In practice, most bonds with call features will be redeemed by the issuer when interest rates have dropped significantly and the issuer can refinance the debt at a lower cost. Conditions that make a call feature valuable to the issuer make bonds with call features less desirable to investors. Because of this, purchasers of callable bonds will typically demand a higher yield at purchase for a callable bond than for a similar bond without the call feature. All mortgage bonds have call features that are exercisable by the mortgage holders by refinancing. This call feature is the main reason that mortgage securities trade at a higher yield than comparable Treasury securities.

Liquidity Risk

Liquidity risk refers to the ease with which a security can be purchased or sold. Bonds that trade frequently and in large amounts, such as Treasury securities, usually have less liquidity risk than bonds which trade less frequently. Liquidity risk is usually indicated by the difference between the bid, or the price at which a market maker will purchase a security, and the offer, or the price at which a market maker will sell a security. The difference between the bid and the offer prices represent the cost of trading the security, and the spread between the two reflects the market maker's uncertainty as to the value of the security. Liquidity risk becomes a smaller factor in overall return as an investors holding period lengthens.

Inflation Risk

Inflation risk refers to the risk that the rate of inflation that is experienced by the investor will be higher than anticipated when the bond was purchased, resulting in reduced purchasing power. This risk can be reduced through the use of adjustable rate bonds, whose coupon payments increase or decrease based on the level of a stated index.

Currency Risk

An investor is exposed to currency risk if a bond is denominated in a currency other than his home currency. If the value of the currency in which the bond is denominated decreases in value relative to the investor's home currency, the investor will receive smaller interest and principal payments than were expected. The investor is also exposed to the interest rate risk and market risk that is present in the foreign market where the investment takes place.

Event Risk

Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. This could be an industrial accident or takeover in the case of a corporate bond, or a major natural disaster in the case of a municipal bond.