Are Bonds really a boring investment option?

Fixed Income Investments

Fixed Income investments might be the first-choice investment for risk-averse investors due to relatively lower risk compared to equity investments. Bond markets offer a plethora of investible securities ranging from high-risk to low-risk.

Acquaint yourself with bond basics – Fixed Income Securities – A look Into Bonds & A Guide to Bond ETFs

Sovereign debt is considered as the most low-risk investment, as the issuer of these fixed income securities are the government of countries. Conversely, the high-yield bonds or non-investment grade bonds are considered among high-risk investments in the fixed income universe.

Risk Factors in Bonds

The risk factors discussed below are pervasive for the whole bond market. However, there could be many idiosyncratic risks associated with the companies. One must perform an in-depth analysis of the company’s fundamentals to understand specific risks prior to investing in corporate bonds.

Default Risk

It is the primary risk associated with any fixed income investments that is triggered when the issuer fails to make the interest payment on the due date or fails to repay the principal amount on the due date.

Interest Rate Risk

Rising interest rates are one of the major risks in holding a portfolio of bonds. Usually, the interest rates and prices of bonds are inversely correlated; therefore, if the interest rates are rising, the bond prices would fall and vice versa.

Investors should consider the duration of the bond prior to investing, and assess the interest rate outlook for the future, as it would allow the investors to get familiar with the probable price volatility arising out of fluctuations in interest rates.

Inflation Risk

Inflation shrinks the purchasing power of a bond’s impending coupon payments and principal, and as bonds don’t offer relatively higher returns, it becomes unfavourable for the investors when inflation is rising.

As a result of rising inflation, the central banks tend to tighten the monetary policy or raise interest rates, resulting in a potential fall in the price of bonds.

Liquidity Risk

Liquidity risk arises when the investors find it difficult to liquidate the bond holdings or fail to find buyers. As a result, the investors may have to sell the bond holdings at a significant discount to the market value.

In corporate bonds, the investors usually enter positions in bonds at the time when they are issued, as the liquidity tends to be relatively better at the time of issue. However, sovereign debt usually commands better liquidity.

Reinvestment Risk

Some bonds allow the issuer to redeem bonds upon the fulfilment of a certain condition, and these are called callable bonds. Typically, the corporations utilise these options when interest rates are falling, enabling corporations to re-issue bonds with the similar principal but a lower a rate.

Therefore, the investors have to sacrifice the higher yields on the bonds denominated at higher rates with new bonds denominated at lower interest rates.

Event Risk

Corporate restructuring undertaken by the corporation put their bonds in an event risk, as events in corporate restructuring could trigger a re-rating by the credit rating agencies due to a change in the financial profile of a new entity or post-transaction entity.

Credit Ratings

Fixed income securities in the bond market are broadly classified in terms of risk or creditworthiness by the credit rating agencies. These agencies measure the risk in fixed income securities through evaluating the financial metrics of the issuer.

Credit rating agencies provide a rating on the debt of the issuer, which ultimately classifies the debt as non-investment grade or investment grade. These ratings on the debt issued by corporations allow investors to perceive the risk of default associated with the investment.

Credit Ratings, Source: Moody’s, S&P, Fitch

Types of bonds based on ratings;

High-Yield Bonds

Fixed income securities rated as Ba1, BB+ and BB+ or below by Moody’s, S&P and Fitch, respectively, are considered as non-investment grade bonds. Securities below this rating bar are also known as high yield bonds or junk bonds.

As the risk in high-yield bonds is relatively higher than the investment grade bonds, the coupon rate or interest rate in high-yield bonds tend to relatively more than the investment grade bonds as well.

High-yield bonds include issuers that are financially vulnerable, highly leveraged, and small companies might be a part of high-yield classification due to their unproven history in financial terms.

Investment Grade Bonds

Fixed income securities rated as Baa3, BBB- and BBB- or above by Moody’s, S&P and Fitch, respectively, are considered as investment grade bonds. All of the bonds rated above this bar are classified as investment grade bonds.

In contrast to high-yield bonds, the investment grade bonds have relatively lower risk, allowing investment grade bonds to have a lower interest rate compared to the high-yield bonds.

Investment grade companies include names with stable business, diversified revenue streams, higher cash flows, less leveraged, strong financial history etc.

Rating Agencies & Financial Crisis

Credit rating agencies had an extensive role in the build-up to the global financial crisis that was triggered by the subprime mortgage crisis in the US. In the 2008 crisis, the credit rating agencies were responsible for giving AAA ratings to structured products that were made up of underlying subprime mortgage.

The agencies had aimed to provide relatively better ratings to underperforming assets in order to maintain their market share and profits. As a result, the rating agencies were accused of conflict of interest, and faulty methodologies in the rating of financial products.

When the housing market started to collapse, it triggered a re-rating for the structured products that had underlying subprime mortgages. As a result, these structured products were re-rated adversely by the credit rating agencies.

Conclusion

Bonds could be a compelling investment for conservative investors or risk-averse investors due to relatively lower risk than equity investments. In the meantime, fixed income investments pay interest or coupon payments, as a regular income stream for investors.

Since interest rates have come down globally, it has partially led to lower yields in bonds, in turn, the prices of bonds have gone up significantly, resulting in substantial capital gains for the bond investors.

Although, high quality bonds have been sitting in the negative territory, and in August, the capital in negatively-yielding bonds reached around USD 17 trillion.

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