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The most well-known risk in the bond market is interest rate risk – the risk that bond prices will fall as interest rates rise. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a set period. Should the market interest rate rise from the date of the bond's purchase, the bond's price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond.

Interest Rate Risk Factors For Bonds

Market interest rates are a function of several factors, including the demand for and supply of money in the economy, the inflation rate, the stage that the business cycle is in, and the government's monetary and fiscal policies.

From a mathematical standpoint, interest-rate risk refers to the inverse relationship between the price of a bond and market interest rates. To explain, if an investor purchased a 5% coupon, 10-year corporate bond that is selling at par value, the present value of the $1,000 par value bond would be $614. This amount represents the amount of money that is needed today to be invested at an annual rate of 5% per year over a 10-year period, in order to have $1,000 when the bond reaches maturity.

Now, if interest rates increase to 6%, the present value of the bond would be $558, because it would only take $558 invested today at an annual rate of 6% for 10 years to accumulate $1,000. In contrast, if interest rates decreased to 4%, the present value of the bond would be $676. As you can see from the difference in the present value of these bond prices, there truly is an inverse relationship between the price of a bond and market interest rates, at least from a mathematical standpoint.

From the standpoint of supply and demand, the concept of interest-rate risk is also straightforward to understand. For example, if an investor purchased a 5% coupon and 10-year corporate bond that is selling at par value, the investor would expect to receive $50 per year, plus the repayment of the $1,000 principal investment when the bond reaches maturity.

Now, let's determine what would happen if market interest rates increased by one percentage point. Under this scenario, a newly issued bond with similar characteristics as the originally issued bond would pay a coupon amount of 6%, assuming that it is offered at par value.

For this reason, under a rising interest rate environment, the issuer of the original bond would find it difficult to find a buyer willing to pay par value for their bond, because a buyer could purchase a newly issued bond in the market that is paying a higher coupon amount. As a result, the issuer would have to sell her bond at a discount from par value in order to attract a buyer. As you can probably imagine, the discount on the price of the bond would be the amount that would make a buyer indifferent in terms of purchasing the original bond with a 5% coupon amount, or the newly issued bond with a more favorable coupon rate.

The inverse relationship between market interest rates and bond prices holds true under a falling interest-rate environment as well. However, the originally issued bond would now be selling at a premium above par value, because the coupon payments associated with this bond would be greater than the coupon payments offered on newly issued bonds. As you may now be able to infer, the relationship between the price of a bond and market interest rates is simply explained by the supply and demand for a bond in a changing interest-rate environment.

Despite its significance on the fixed-income market, interest rate risk is not the only risk of investing in bonds; reinvestment risk, call risk, default risk and inflation risk are just a few of the additional types of risk for bond investors (For further reading on types of bond risk, see: Six Biggest Bond Risks).

Reinvestment Risk for Bond Investors

One risk is that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120 (12% * $1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond.

Call Risk for Bond Investors

Another risk is that a bond will be called by its issuer. Callable bonds have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs.

Default Risk for Bond Investors

This risk refers to an event wherein the bond's issuer is unable to pay the contractual interest or principal on the bond in a timely manner, or at all. Credit ratings services such as Moody's, Standard & Poor's and Fitch give credit ratings to bond issues, which helps to give investors an idea of how likely it is that a payment default will occur.

For example, most federal governments have very high credit ratings (AAA); they can raise taxes or print money to pay debts, making default unlikely. However, small emerging companies have some of the worst credit (BB and lower). They are much more likely to default on their bond payments, in which case bondholders will likely lose all or most of their investments.

Inflation Risk for Bond Investors

This risk refers to an event wherein the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception.

For example, if an investor purchases a 5% fixed bond, and then inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted periodically to match inflation rates, limiting investors' exposure to inflation risk.

For further reading, see What Is A Corporate Credit Rating?, Bond Call Features: Don't Get Caught Off Guard and our Bond Basics Tutorial.

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