Portfolio Risks - Bond Risks
While more publicity is given to risk in the stock markets, there are a number of risks associated with investing in bonds:
Call risk - When interest rates fall, a callable bond is more likely to be called in, and the investor would have to replace it with a lower-coupon bond.
Reinvestment risk - This can refer to reinvestment of principal after a bond is called, as well as reinvestment of the dividends from a high-coupon bond into a lower-rate investment.
Credit risk - This refers to the possibility that the bond issuer will not be able to make expected interest rate payments and/or principal repayment.
Interest rate risk - If interest rates rise, the market value of the bond will decline. This is less of an issue if the investor can hold the bond until it matures.
Purchasing power risk - Also known as inflation risk, this refers to the very real possibility that as inflation increases the purchasing power of the bond income will decrease.
Liquidity risk - This refers to the marketability of the bond. Certain issuers may be less marketable than others.
Event risk - Any number of events can affect the credit-worthiness of the issuer. Leveraged buyouts, corporate restructurings, mergers and acquisitions, and bankruptcies can all have a negative impact on a bond's price.
Opportunity cost risk - This refers to the potentially higher rate of return an investor could earn if the money used to purchase a bond were placed in an alternate investment.
- Currency risk - Also known as exchange risk, this risk applies only to foreign bonds.
Before we delve into duration, the primary measure of bond risk, we recommend a read of the following tutorials. If the topic of bonds is unfamiliar to you, or you need a brush up on their basics, see our Bond Basics Tutorial.
If you are fairly familiar with bonds, move on to our Advanced Bond Tutorial , which focuses on bond fundamentals such pricing, yield, and duration.
Note that the inclusion of these tutorials is so you better understand the concept of duration. You will most likely not be asked bond-specific questions on your Series 66 exam. (You will need to know this material for your Series 7 exam, however).
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