An Investor’s Guide to Bonds Risks
Are there any risks in bond trading?
As with all other investment products, bonds are not without a certain level of risk on the side of the investor. Bonds carry the risk that issuers will not be able to pay interest or - in extreme cases - will not be able to repay the bond at all.
Many bond issuers have a rating, which investors can use to guide their investment decisions. Professional rating agencies assess the creditworthiness of issuers and summarise their assessment in grades ranging from AAA to D with AAA being the best possible rating. This rating process assesses the likelihood of the company or the public authority who issued the bond to repay the loan and its interest.
When entering into the bond market, it is important for an investor inform themselves on:
- The characteristics of the bond: Type of bond, interest rate, price, maturity, etc.
- The company or the public authority that is issuing the bond: Reputation, rating etc.
In relation to the bond itself
When companies or public authorities want to issue a bond, they prepare a prospectus. It is important for investors to read this document very carefully. A well-made prospectus should contain many – if not all - of the main elements needed in order to understand all elements of a given bond.
The prospectus for each security that is officially listed on the Luxembourg Stock Exchange, may be downloaded free of charge from the respective security card on www.bourse.lu.
In relation to the bond issuer
It is important to properly assess whether the company or the public authority issuing the bond will be able to reimburse its investors in the future. That is, after all, why one would invest in a bond in the first place; to get their money back at maturity and benefit from interest payments over the entire lending period. Always keep in mind that bonds with high interest normally involve higher risk factors.
Annual reports, financial articles, historical market data and analyst reports can also help to give investors a good overview of the company or public authority issuing the bond. Some documentation as the latest notices from companies that officially list their bonds on the Luxembourg Stock Exchange may also be found on LuxXPrime website. It is also important to read up on financial information regularly in relevant newspapers or magazines. This will allow investors to better perceive the economic climate and potential changes in the market that may affect their investment.
Furthermore, it is important to understand the degree of risk associated with different types of investments and how the expected return is may affected by this. Bonds with a higher level of risk will generally have a higher rate of return attached and vice versa. That is why most bonds pay lower returns than shares and other riskier investments, such as so-called ‘junk bonds’ which pay much higher returns than safer and more secure bonds.
Unlike equities, bonds generally provide greater certainty as to their income stream and return of capital. The regular interest income and principal repayments at maturity provide indeed a comforting level of security.
Last but not least, there are also some risks related to the interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. In case of a floating rate bond, the yield on the bond can usually be expected to stay in line with current interest rates, so movements in interest rates generally should have very little impact on its price. However, in case of a fixed rate bond, the yield on the bond can only keep pace with changing interest rates if the price of the bond changes. As market interest rates constantly change, a fixed rate bond becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.