Bond Risks
- Default Risk. This is the risk that the borrower will not be able to pay back the principle or make interest payments. In the past, corporate bonds have been looked at as having a higher default risk than government bonds because the government can always print more money, while companies can't. Within the corporate bond sector, junk bonds have a higher default risk than non-junk bonds, which are referred to as "investment grade" bonds. The risk of default is rated by the popular credit-rating agencies, Moody's and Stnadard & Poors. Despite the recent criticism of the credit ratings agencies role in the market meltdown of 2008, they do a very good overall job when it comes to rating bond default risk.
- Interest Rate Risk. This is the risk that bond prices will fall due to a rise in interest rates. The longer the maturity of a bond, the greater the interest rate risk will be because longer-term bonds are more sensitive to interest-rate changes than shorter-term bonds. Sometimes this is called "Duration Risk".
- Liquidity Risk. This is the risk that there won't enough buyers if you want to sell your bond. Liquidity risk is a risk that applies to any security, and is not specific to bonds. Liquidity risk can be a result of owning bonds within a market which is not very large (supply-side liquidity risk). For example, when Long Term Capital Management bought Russian bonds and the Russian bond market dropped, there was no liquidity in the market and they had trouble finding buyers because the Russian bond market is such a small market. Liquidity risk can also be a result of someone having a very large position in a security (demand-side liquidity risk). For example, if a large investor (Fidelity for example) owns 20% of a company's stock (say 200 million shares) then they can't just log onto E*Trade and sell all those shares because there won't be enough buyers. They need to call around for a long-time in order to find enough buyers. Although this example used stocks, the same principle applies to bonds.
- Market risk. This is due to the bond prices in general dropping due to market movements. For examples, bond prices may drop because investors are switching out of bonds and into stocks (i.e. asset allocation) or any other reasons.
- Inflation risk. Inflation devalues money. This means that the future interest paid out from the bonds to bondholders will also be worth less. So the price of bonds will fall to compensate for this. Also, inflation usually leads to a rise in interest rates, which devalues bonds.
Intro to Stocks
