What are the risk of investing in bonds

 

Most of the authorized-pooled funds marketed by the MPF service providers are invested into bonds and equities. I shall outline some of the characteristics of these two investment vehicles.

 

Bonds

Bonds are instruments issued by borrowers to raise fund from the market. Issuers can be government bodies (e.g. USA, Canada, Japan & HK), supranational (e.g. World Bank, Asian Development Bank), corporations (e.g. IBM, General Electric, Mass Transit Railway). Bonds normally provide a fixed coupon (e.g. 6%p.a.) and repayment of principal at the end of an agreed time period.

 

Therefore, by investing into bonds, you have a certainty of repayment of principal on the maturity date of the bond as well as certainty of nominal return each year. The volatility of bonds is low and return is also low relative to other investment vehicles. However, bond yields are normally higher than deposits.

Although bonds are quite safe, it does carry certain risks. They include 1. Interest rate risk, 2. Purchasing power risk, 3. Liquidity risk, 4. Credit risk and 5. Specific issue risk.

  1. Interest rate risk

    2. Bonds usually carry a fixed interest rate; i.e. the issuer will pay the holder a fixed interest rate each year. If the market interest rate goes up, the market value of the bond will decline.

  2. Purchasing power risk

    3. In a high inflation environment, investors tend to demand a higher interest rate on bonds. Therefore, bond prices will decline when inflation rises.

  3. Liquidity risk

    4. Some of the bonds (especially bonds issued by corporations) may not be very marketable when the market is difficult. So it may not be easy to sell bonds during such time.

  4. Credit risk

    5. The creditability of the issuer of the bond can have a major impact on bond prices. Most of the major bond issuers are rated by rating agencies. There are two major rating agencies: Standard & Poorˇ¦s and Moodyˇ¦s. They monitor the credit-worthiness of the issuer regularly. Should the financial position of the issuer deteriorate, they will downgrade the rating of the issuer. Bond prices tend to react negatively on such downgrade.

  5. Specific issue risk

Some bonds have special features when they are issued, e.g. issuer have the right to redeem the bond before maturity date. So when interest rate declines, the issuer may redeem the bond early.

Despite the abovementioned risks, bonds are good investments for conservative investors. Therefore, bond investments become a major part of conservative portfolios.

 

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