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F. Risks

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Credit risk or default risk
Credit risk is the risk that the issuer of a bond may default i.e. that they are unable to make good on their promise either to make timely interest payments or to repay principal at maturity.

Credit risk is gauged by quality ratings assigned to issuers by commercial rating companies; ratings.

Due to this risk most bonds trade at a spread to US or European Government Bonds ( usually Germany) which are also referred to as “Risk-free”. This spread is defined as “risk-spread”. If the bond’s price stays stable despite a decline in US treasury prices, this implies “tightening of risk spread” the reverse implies “widening of risk spread”

In practice, with the exception of high yield (or junk) bonds, very few bond issuers are going to default. So what the investor is more concerned with are changing credit ratings, which will have an immediate impact on the price of an issuer's outstanding and new debt. Basically, if an issuer's credit rating is downgraded so will the price of its bonds; creating the potential for significant capital losses for bondholders who want to sell before maturity. A negative rating implied a deterioration of the issuer’s paying abilities and its finances.


Market or interest rate risk
The most significant risk faced by bondholders is market or interest rate risk. The price of a bond typically moves in the opposite direction to a change in interest rates. If you are holding to maturity this doesn’t matter; but if you need or want to sell before maturity a fall in price will realise a capital loss. This risk of capital loss is referred to as market or interest rate risk.

Modified duration indicated the effect of the interest rate difference on the price of the bond.


Reinvestment risk
The basis assumption behind the yield to maturity calculation is that all coupon gains are reinvested at the coupon rate. However there is a risk that market rates fall during the life of the bond and that you cannot reinvest at the coupon rate.

The longer the bond, the greater the reinvestment risk is. The only kind of bond which doesn't have any reinvestment risk is the zero coupon bond.


Inflation risk
Inflation risk is the risk of inflation reducing the value of the cash flows from a bond in terms of their purchasing power.

Investors are exposed to inflation risk because the payments a bond promises to make are – with the exception of floating rate notes – fixed for the life of the security.


Liquidity risk
Liquidity implies the ability to execute transaction in the bond in large sizes without significant changes in the price. A very actively traded market, where it is easy to sell whatever you are holding for cash without discounting its price heavily is said to be a liquid market. A market where it is difficult to sell whatever you are holding for cash unless its price is discounted is said to be an illiquid market.

If you plan to hold a bond to maturity liquidity risk is irrelevant. If you want to sell before maturity it is highly relevant.


Political or legal risk
This is the risk that government or some other relevant authority imposes some new tax or legal restriction on the security you have already bought.


Event risk
These are things like natural or industrial disasters or major corporate actions – takeovers, restructurings and so on. They are outside the control of the issuer or the market but – if they are significant enough – they can obviously have an effect on the issuers’ ability to meet its obligations.