A bond is an asset class along with stocks and cash equivalents (Investopedia, 2011). Bonds are loans offered to corporates or governments by investors to be paid in a specified period. They are normally attached to a fixed interest rate, unlike normal loans. Bonds in most cases are used by big corporations and governments to finance different projects. They are, therefore, referred to as fixed-income securities due to their nature of having a fixed interest.
The corporates and governments or any other entity that seeks to roll out bonds to the public are called the Issuer while the interest rate is known as a Coupon. The cash loaned, which is the Bond principal, is paid back after the agreed period expires and is referred to as the Maturity date. There are different types of bonds which include corporate bonds, municipal bonds, and treasury bonds. A bond is characterized by two of its features which are the credit quality and duration (Investopedia, 2011).
Treasury bonds are normally short-term bonds that normally go for about 90 days. The corporate and municipal bonds may go between three to ten years. Government bonds are the longest as they go for up to 30 years before reaching maturity (Ehrhardt & Brigham, 2010). The term risk in finance is used to refer to the possibility of losing money during a particular transaction or the possibility of not making financial returns in a certain financial engagement.
Risks are categorized into seven major categories which include asset-back risk, credit risk, foreign investment risk, liquidity risk, operational risk, and model risk (Investopedia U.S. Securities and Exchange Commission, 2011). Risks associated with bonds will therefore be under the asset-backed risk category. Although bonds are a good method of investment, there are several risks associated with them. Nonetheless, compared to stocks which fluctuate now and then, bonds are more secure.
However, both expose investors to risks. The first very common risk involved in bonds is the interest rate risk. With a low-interest rate, the bond prices escalate while a higher interest rate attracts a decline in the bond prices. Another risk is the reinvestment risk especially in the case of callable bonds. When an issuer decides to redeem bonds before maturity, the investors get their principal payment which leaves them in no position to reinvest at the same interest rate (Ehrhardt & Brigham, 2010).
This affects the general investment returns in the long run. Inflation risk is the third risk associated with bonds. As time goes by and inflation rises, the impact will be that the investor’s purchasing power declines due to the high cost of living due to inflation. Inflation significantly reduces the value of the bond investment as the purchasing power decreases. Other than inflation risk, credit/default risk can also be listed in the list (Investopedia, 2011).
When purchasing a bond, investors commit their finances to corporates under the assumption the corporates will be able to pay the money back. This is a risk because there are factors that can lead to an anticipated inability to repay the debts hence exposing investors to a very high level of risk. Other risks include liquidity risks and rating downgrades (Investopedia, 2010).
All the same, bonds can generate high margin profit for investors, but it depends on the nature of the issue. But to be safe in this market, investors must keep their eyes open and consider the above-mentioned risks before engaging in any bond purchasing process.
Ehrhardt, M., C. & Brigham, E., F. (2010). Corporate Finance: A Focused Approach. New York, NY: South-Western Publishing Co.
Investopedia: 6 Biggest Bond Risks. (2010). Web.
Investopedia: Definition of Bonds. (2011). Web.