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Risk associated with fixed-income securities
Investments in fixed-income securities cannot be considered purely risk free. Such investments can have the following three types of risks associated with them:
1. Interest Rate Risk
2. Reinvestment Risk
3. Default Risk
Interest Rate Risk
Interest rate risk exists when the prevailing market interest rate rises, resulting in an increase in the expected rate of return for the bond holder; however, an increase in the discount rate reduces the bond's present value.
Example: Suppose you purchase a bond with a coupon rate of 7%, and now the coupon rate prevailing in the market increases to 7.5%. Now, investors will prefer to invest in those bonds that provide a 7.5% coupon rate instead of a 7% coupon rate, and the market price of the bond with a 7% coupon rate decreases.
Reinvestment Risk
Reinvestment Risk is alive when the prevailing market interest rate will decrease, resulting in an increase in the current market price of the existing bonds; however, the bond will reach its maturity date, and once the investor gets the redemption price on maturity, the reinvestment of such amount cannot be made at the previous coupon rate, and hence the investor has to invest that money at the lower coupon rate, which reduces income for the investor.
Example: Assume you buy a bond with a 7% coupon rate and the market coupon rate falls to 6.5%; investors will prefer to invest in bonds with a 7% coupon rate rather than a 6.5% coupon rate, so the market price of the bond with a 7% coupon rate rises; however, when the bond matures, you can reinvest your maturity amount at the reduced interest rate of 6.5% rather than the previous 7%.
Default Risk
Default risk exists when the issuer of fixed-income securities becomes insolvent and is unable to repay its debt despite selling all of its business assets. Although debt holders have first priority in receiving their money, in some situations, even after this, business assets are not enough to repay money to all their debt holders. In such cases, investors have to face default risk. Sometimes even top-rated fixed-income securities default, like at the time of the sub-prime crisis with collateralized debt obligations (CDOs).
Example: investors who invested in Lehman Brothers debt securities during the subprime mortgage crisis, which were declared insolvent on September 15, 2008, are still unable to repay their debt to the investors. Despite the fact that the majority of the securities were top-rated by credit rating agencies, they still faced the default risk of Lehman Brothers, the most valuable investment bank at that time.
2. Reinvestment Risk
3. Default Risk
Interest rate risk exists when the prevailing market interest rate rises, resulting in an increase in the expected rate of return for the bond holder; however, an increase in the discount rate reduces the bond's present value.
Example: Suppose you purchase a bond with a coupon rate of 7%, and now the coupon rate prevailing in the market increases to 7.5%. Now, investors will prefer to invest in those bonds that provide a 7.5% coupon rate instead of a 7% coupon rate, and the market price of the bond with a 7% coupon rate decreases.
Reinvestment Risk
Reinvestment Risk is alive when the prevailing market interest rate will decrease, resulting in an increase in the current market price of the existing bonds; however, the bond will reach its maturity date, and once the investor gets the redemption price on maturity, the reinvestment of such amount cannot be made at the previous coupon rate, and hence the investor has to invest that money at the lower coupon rate, which reduces income for the investor.
Example: Assume you buy a bond with a 7% coupon rate and the market coupon rate falls to 6.5%; investors will prefer to invest in bonds with a 7% coupon rate rather than a 6.5% coupon rate, so the market price of the bond with a 7% coupon rate rises; however, when the bond matures, you can reinvest your maturity amount at the reduced interest rate of 6.5% rather than the previous 7%.
Default Risk
Default risk exists when the issuer of fixed-income securities becomes insolvent and is unable to repay its debt despite selling all of its business assets. Although debt holders have first priority in receiving their money, in some situations, even after this, business assets are not enough to repay money to all their debt holders. In such cases, investors have to face default risk. Sometimes even top-rated fixed-income securities default, like at the time of the sub-prime crisis with collateralized debt obligations (CDOs).
Example: investors who invested in Lehman Brothers debt securities during the subprime mortgage crisis, which were declared insolvent on September 15, 2008, are still unable to repay their debt to the investors. Despite the fact that the majority of the securities were top-rated by credit rating agencies, they still faced the default risk of Lehman Brothers, the most valuable investment bank at that time.
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