Understanding the risks of investing in bonds

By knowing and understanding the risks associated with their investments, investors can limit unnecessary loss to their investments.

THIS third article of our bond series seeks to show where bonds stand in the risk/reward spectrum compared to other investments and explain the risks involved when investing in bonds. Risk, an undeniable important element, needs to be understood as all investments carry with them some amount of risk.

How Bonds Compare With OtherInvestments in the Risk/Reward Spectrum

All investments offer a balance between risk and potential return. The balance between risk and return varies depending on the type of investment. Generally, the riskier the investment, the greater is the reward. The Diagram on the right shows that bonds are riskier and more rewarding than fixed deposits, but are less risky and thus less rewarding than equities.

What Are the Risks of Investing in Bonds?

Investors need to realise that investing in bonds entail risks which could affect the values of bonds. There are many types of risks associated with bonds but this article will touch only on a few significant ones.

* Interest Rate Risk

Interest rate risk is the risk of rising market interest rates that will reduce the market price of a bond. This is because bond prices have an inverse relationship with market interest rates. If market interest rates increase, the price of the bond will decrease and vice versa.

By buying a bond, the bondholder will receive a coupon rate (fixed interest payment) from the issuer for the entire life of the bond. This stated coupon rate is predetermined at the time when the bond was issued depending on the issuer's projected repayment ability in the future.

The coupon is a fixed payment which cannot be changed over the life of the bond even if market interest rates change. Therefore, should the market interest rates rise, bonds which pay less than this rate will become unattractive and the bond's price will fall accordingly.

For example, if the coupon is set at 10 per cent and market interest rates increase to 20 per cent, the price of the bond will decrease. This will lower the value and returns that the bondholder can make on the bond.

* Credit Risk

Credit risk, also known as default risk, is the risk of bond issuer not being able to meet its interest and debt obligation to its bondholders. If the bond issuer cannot repay principal and interest on time, the bond is said to be in default and all investors' investments are lost.

There is a rating system that enables investors to know the amount of credit risk each class of bond entails.

In Malaysia, the ratings of credit quality of bonds are undertaken by bond rating agencies, namely Rating Agency Malaysia Bhd (RAM) and Malaysian Rating Corp Bhd (MARC). These credit ratings services help investors to gauge the likelihood of the issuers not being able to fulfil their obligations.

For instance, bonds issued by governments usually have very high credit ratings as they are deemed risk-free. This is because governments have the ability to generate revenues through taxation or reprint money to repay the bondholders.

Bonds issued by corporations, on the other hand, can start from AAA (highest quality) to D (lowest quality or defaulted). Bonds which are ascribed ratings of BBB and above are "investment grade" bonds while those which are below BBB are "non-investment" grade bonds.

Ratings are ascribed differently to corporations depending on their financial stability and the prospect of their business models and ventures. Non-investment grade bonds carry higher yields compared to investment grade bonds as investors need to be compensated for taking additional risk.

* Inflation Risk

Inflation risk is the risk that investor's investment (principal and coupon received) may not grow or generate income at a rate that keeps pace with inflation. Rising prices make today's money worth less in the future than they are worth today. When a bond locks up money for as long as 10 years, rising rate of inflation can have an eroding effect. The impact of this risk is more so for longer tenure bonds with fixed interest rates.

For illustration to show how inflation can erode an investor's investment, assume an investor invests RM100 million in a bond which gives 10 per cent coupon rate, but inflation is at 5 per cent per year. Although the return is RM10 million (10 per cent x RM100 million) after one year, inflation cuts the actual worth of this return from RM10 million to RM9.5 million - (100-5) per cent x RM10 million. On top of that, the face value RM100 million is also eroded by the 5 per cent inflation to RM95 million [(100-5) per cent x RM100 million].

To hedge against this risk, investors can maintain the investment value by investing in a bond which has a total return that keeps pace with the inflation rate. For example, an investor can invest in floating-rate bonds which have interest rates that are adjusted periodically to match inflation rates.

* Prepayment Risk

Prepayment risk is the risk of the bond issuer paying back the debt to the bondholders before the bond's maturity date. While it is not as bad as the issuers not paying the debt at all, investors will have to suffer the loss of having to reinvest in lower interest rate bonds or less lucrative investments.

Bonds, such as callable bonds, have terms which allow the issuers to redeem the bonds. Bonds are usually called back by the issuer when the market interest rates have fallen substantially to benefit from lower interest rates.

By doing so, the issuer can redeem the old bonds with high interest rates and then issue new bonds with low interest rates. Unlike the issuers who will benefit from the lower market interest rate, the investor will have to bear the opportunity loss.

Conclusion

Investors need to recognise that all investments are not shielded from risks. By knowing and understanding the risks associated with their investments, investors can limit unnecessary loss to their investments.

As average investors have limited resources and expertise, they could benefit from asset managers' professional management of bond funds. Investors can leverage on fund houses' technical expertise and infrastructure, especially those established ones with proven track records.

With a structured investment process that combines intensive research, vigilant risk management and disciplined portfolio construction, investors can have peace of mind knowing that their investments are guided by distinctive risk-based approach geared to provide potentially greater than average total return.

This article is contributed by the Funds Management Division of AmInvestment Bank Group.