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What is risk? – Bonds

In this series of articles we are considering the different TYPES of RISK we take when investing in different assets. This should help to build a portfolio in which we fully understand what risks each part of the portfolio expose us to.

The term bond is broadly used in the financial industry; here we concentrate on the “investment asset” often known as fixed interest, fixed income or debt securities. Government Bonds have their own specific names too; e.g. UK GILTS, US T-Bills & German BUNDS.

If a company or government needs to raise money and doesn’t want to (or can’t) issue new shares or borrow from a bank they may issue a bond. It promises to repay the bond holder its face value on a set date in the future and until then will pay interest for the loan (the coupon). Bonds are issued on the ‘issue date’ but can be freely traded on the bond market so their price can fluctuate with normal market conditions. The fluctuation in price means that the ‘yield’ changes too – this is the fixed coupon but if bought at a different price gives a different actual yield.

When a company is wound up (e.g. on bankruptcy) the bond holders, as creditors, are repaid from the assets of the company before shareholders; this means that bonds are considered safer to hold than shares. The coupon must also be paid before any dividends. So what risks should we consider before buying bonds:

Default risk – can the bond issuer repay me my coupon every year AND can they pay me back at the end of the term?

Interest rate risk – as rates go up, bond values fall (and vice versa). In a low interest rate environment are we exposing the value of our capital to risk if interest rates are increased?

Market risk – these are investments, and though considered safe a flow of money out of the bond markets because of lack of confidence can affect prices.

Issuer specific risk – a lack of confidence in the future of the company can, like shares, create a selling of the bonds too.

Liquidity risk – if buying smaller company or peripheral government bonds, it can be tricky to sell them should you need to quickly.

SAFETY vs RISK – at the moment developed government and many ‘blue chip’ company bonds are trading at record low yields, and though they are considered SAFE (as they are unlikely to default) this doesn’t mean they are without RISK. If a bond has a yield of 1.5% and interest rates go up by 1% it is possible to lose 10% of the capital value… this is now not LOW RISK.

Buying bonds through a fund can often help reduce many risks; the manager can choose which sectors to invest in or not and can manage the specific risks appropriately. We favour global strategic bond funds as they have a very broad remit and a very large bond universe to invest into.

This article is for information only and should not be considered as advice.
This article is written by Peter Brooke The Spectrum IFA Group

More on risk and investing in different assets