Risks in bonds
Interest rate riskThis refers to the risk that a bond’s price could decline if interest rates rise. As compared to shorter maturity bonds, bonds with a longer time to maturity are more susceptible to price declines when interest rates rise, which means investors in longer-dated bonds require additional compensation for taking on this additional interest rate risk (in the form of higher bond yields, which leads to an upward-sloping yield curve). Of course, an investor holding a bond to maturity (and who ignores mark-to-market price fluctuations) would not worry too much about interest rate risk, as long as the bond’s time to maturity matches the investor’s investment horizon.
Credit riskBonds are subject to the risk of the issuer defaulting on its obligations. It should also be noted that credit ratings are not a guarantee but simply an opinion of the rating agencies. In situations where an issuer’s credit conditions deteriorate rapidly, rating agencies may not be able to react fast enough in evaluating and updating such ratings. A corporate event such as a merger or takeover may lower the credit rating of the bond issuer. If a corporate restructuring is financed by the issuance of a large amount of debt, the company’s ability to pay off existing bonds will be weakened.
Liquidity RiskSome bonds may not have active secondary markets. As such, investors may find it difficult to sell the bond at a preferred price, or even impossible to sell it before its maturity. If the bond is very illiquid, this also creates a wider spread between its bid and ask prices.
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