Risks Associated with Investing in Bonds
1. Interest Rate Risk: Interest rate changes are what may affect bond prices. When lenders require payments of higher interest, investors generally find bonds less attractive. By the same token, bonds usually become more desirable when interest rates decline. Bondholders of long-term bonds are susceptible to the risk of rate changes, as the bonds are highly sensitive to interest rates.
2. Credit Risk: Often referred to as pre-payment risk or interest rate risk, credit risk is the possibility that the issuer of the bond faces difficulty repaying the principal or making payments of the accrued interest, as stipulated in the bond contract. This particular danger is greater for debt of lower-quality grades held by entities in shaky or dire financial positions.
3. Reinvestment Risk: Reinvestment risk manifests itself when the interest or principal payable on a bond is re-invested at a lower rate of interest that precludes its compilation. Short-term refinancing is quite frequent in callable bonds where the issuer has a buyback or call feature, which gives it the opportunity to redeem the bond ahead of maturity and refinance at more favorable rates.
4. Inflation Risk: Inflation grabs unwanted attention by diminishing the purchasing power of future cash flows from bonds and reducing yields on debt securities. The weaker bonds that are not backed by inflation protection and rather by traditional fixed-rate bonds (cited hereinafter as âstandardâ bonds) assume the greatest risk of inflation.
5. Call Risk: Redemption of bonds with a call feature at a predetermined price is held by the issuer one prior to the maturity date. This increases the call risk since some bondholders might be asked by their issuers to return their bonds to financial institutions, particularly when there is a huge upsurge in interest rates.
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