Returns
With a bond, investors have two sources of return: interest payments in the form of regular coupon payments and price fluctuations. Generally, however, the bond’s interest payments are the primary focus, as they account for the majority of the return. Typically, the return is paid annually in arrears (“annual coupons”), but there are also bonds with semi-annual or quarterly coupons.
Risks
Depending on their structure, bonds carry various risks. Since bonds generally have a fixed interest rate – which usually represents the largest portion of the return – they are generally considered safer than equity securities.
The following risks can be distinguished in relation to bonds:
- Price risk (= risk of interest rate changes)
- Issuer credit risk
- Currency risk (only for foreign-currency bonds)
- Liquidity risk
- Call risk
Price risk (= risk of interest rate changes)
The risk of price losses, as well as the opportunity for price gains, arises from changes in market interest rates. If market interest rates rise, the prices of existing (i.e., already issued) bonds fall; if market interest rates fall, the prices of existing bonds rise. All bonds are subject to price fluctuations. However, since redemption occurs at par value, these fluctuations are of no further significance to investors who hold the bond until maturity.
Issuer credit risk
Credit risk refers to the risk that an issuer will only be able to repay the capital entrusted to it (e.g., in the form of issued bonds) in part or not at all. Credit risk reflects the quality or creditworthiness of a debtor.
Generally, the better an issuer’s creditworthiness, the safer the bond and the lower the probability of default. Issuers with a higher probability of default must offer a higher interest rate (a risk premium) on new bonds in order to attract investors. Creditworthiness is determined by a credit rating assigned by rating agencies.
Currency risk
For bonds denominated in a foreign currency, exchange rate fluctuations of the foreign currency against the euro can create risks or opportunities. If you hold a U.S. dollar bond whose interest is paid in U.S. dollars, a decline in the value of the dollar can reduce the interest payment in euros. A loss may also occur upon redemption of the bond if the dollar exchange rate at the time of redemption is lower than it was when the bond was purchased (since you receive fewer euros for the same amount of dollars). Conversely, currency gains may also arise.
Liquidity risk
Liquidity risk refers to the risk that you will be unable to sell your bond to other investors if you need cash before maturity. To minimize liquidity risk, it is advisable to purchase bonds that have already been placed on the market and have a high volume of issuance.
Call risk
To mitigate the risk of persistently high interest payments, many issuers include an early call option in the bond terms. Called amounts may only be reinvested at a lower interest rate prevailing at that time.
