13.4: Fixed Income Risks

Risk in theoretical finance is defined mathematically usually as the chance or extent to which the actual return may differ from the required or expected return.

“Differ” allows for the actual or “realized” return to be either less or greater than the expected return.

From the investor’s perspective, bond risks may be divided into the following qualitative components:

Liquidity Risk – the risk that the security cannot be converted to cash at its reasonable intrinsic or “fair market value” due, possibly, to a lack of buyers.

Credit- or Default Risk – the possibility that a corporation may, in the worst case, go bankrupt, or, in a lesser case, not honor its interest and other related payments timely and in full.

Inflation Risk – the risk that the return , i.e., the interest payments, will be eroded over time by inflation, i.e., a reduction in the purchasing power of the interest payments .

• Note that, in most cases, interest payments are fixed.
• Many governments sell inflation-linked, or inflation-indexed bonds that have payouts linked to the inflation rate. The United States Treasury sells Treasury Inflation-Protected Securities (TIPS).

Interest Rate (or “Price”) Risk – the negative effect on market value s , or price s , due to rising levels of general interest rates.

Reinvestment Rate Risk – the risk that cash interest payments received during the life of a bond will be reinvested at less than the rate originally expected, thereby reducing the overall holding period return .

Country or Sovereign Risk – for example, war, changes in administration, etc.

Foreign Currency Risk – possible negative effect of repatriation of funds