Owning Bonds

The basic risk of bond investing is that the returns – the coupon and the principal repayment (face value) – will not be repaid, or that when they are repaid, they won't be worth as much as you thought they would be. The risk that the company will be unable to make its payments is default risk – the risk that it will default on the bond. You can estimate default risk by looking at the bond rating as well as the economic, sector, and firm-specific factors that define the company's soundness.

Part of a bond's value is that you can expect regular coupon payments in cash. You could spend the money or reinvest it. There is a risk, however, that when you go to reinvest the coupon, you will not find another investment opportunity that will pay as high a return because interest rates and yields have fallen. This is called reinvestment risk. Your coupons are the amount you thought they would be, but they are not worth as much as you expected, because you cannot earn as much from them.

If interest rates and bond yields have dropped, your fixed-rate bond, which is still paying the now-higher-than-other-bonds coupon, has become more valuable. Its market price has risen. But the only way to realize the gain from the higher price is to sell the bond, and then you won't have any place to invest the proceeds in other bonds to earn as much return.

Reinvestment risk is one facet of interest rate risk, which arises from the fundamental relationship between bond values and interest rates. Interest rate risk is the risk that a change in prevailing interest rates will change bond value – that interest rates will rise and the market value of the bond will fall. (If interest rates fell, the bond value would increase, which the investor would not see as a risk).

Another threat to the value of your coupons and principal repayment is inflation. Inflation risk is the risk that your coupons and principal repayment will not be worth as much as you thought, because inflation has decreased the purchasing power or the value of the dollars you receive.

A bond's features can make it more or less vulnerable to these risks. In general, the longer the term to maturity is, the riskier the bond is. The longer the term is, the greater the probability that the bond will be affected by a change in interest rates, a period of inflation, or a damaging business cycle.

In general, the lower the coupon rate and the smaller the coupon, the more sensitive the bond will be to a change in interest rates. The lower the coupon rate and the smaller the coupon, the more of the bond's return comes from the repayment of principal, which only happens at maturity. More of your return is deferred until maturity, which also makes it more sensitive to interest rate risk. A bond with a larger coupon provides more liquidity, over the term of the bond, and less exposure to risk. Figure 16.5 "Bond Characteristics and Risks" shows the relationship between bond characteristics and risks.

Figure 16.5 Bond Characteristics and Risks

A zero-coupon bond offers the lowest coupon rate possible: zero. Investors avoid reinvestment risk since the only return – and reinvestment opportunity – comes when the principal is returned at maturity. However, a "zero" is exposed to the maximum interest rate risk, because interest rates will always be higher than its coupon rate of zero. The attraction of a zero is that it can be bought for a very low price.

As a bond investor, you can make better decisions if you understand how the characteristics of bonds affect their risks and yields as you use those yields to compare and choose bonds.