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Bond Risk: Definition & Types

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you'll learn the definition and the different types of bond risk, which include credit/default risk, interest rate risk, inflation rate risk, reinvestment risk, and liquidity risk.

Bond Investment

'You know what would be good with this coffee? A nice warm blueberry muffin,' replied your grandmother as she answered her own question. 'I'm surprised this coffee shop doesn't serve food. Oh well, that's beside the point.' Now looking directly at you, she says, 'I asked to meet with you today because your grandfather and I want to invest money for our retirement. And we want to invest that money in bonds. We've been reading about them and we like the steady income they generate, but we have a few questions we hope you can answer. The first is what is bond risk? And how should we think about this as it relates to our investment?'

Bond Risk

'Great questions,' you reply. 'We'll define bond risk as the risk you'll lose money on your bond investment. That's really what you should be concerned about. There are a few ways you can lose money. We'll highlight five different types of risk, including credit/default risk, interest rate risk, inflation rate risk, reinvestment risk, and liquidity risk. Let's come up with an example that will put these risks into context. Let's imagine you and Grandpa lend money to this coffee house, so they can buy the equipment necessary to serve food instead of just coffee. You and Grandpa lend them $10,000. The coffee shop signs a contract obligating themselves to pay you 5% interest at the end of each year for the next 20 years. This is a bond contract. You've invested your $10,000 in a bond!

Credit Risk

'Now, the first thing you will likely think about is whether or not the coffee shop can earn enough money to pay your $500 in interest every year ($10,000 x 5%). This is referred to as credit risk (or default risk), and this is the risk of the borrower (i.e. the coffee shop) failing to make its required payments. Before making the investment, you need to be sure that the coffee shop will earn enough money every year by selling coffee and its new food to customers to safely cover your interest payments over the next 20 years.

Interest Rate Risk

Twenty years is a long time, but many bond contracts can last 20+ years. Another risk you and Grandpa need to consider is interest rate risk. This is the risk that changes in borrowing rates which may reduce, or increase the market value of a bond you hold. In our example, 5% is the interest rate. Let's say after the contract is signed, everyone is happy. But the very next day, borrowing rates rise considerably to 10%. This means if you had waited just one more day to sign the bond contract, you and the coffee shop would have agreed to 10% as the interest rate. There are several things that could have caused the interest rate to rise such as the inflation rate, or the government forcing banks to borrow from each other at higher rates. You and Grandpa would be very unhappy if this happened because instead of receiving $1,000 every year in interest payments ($10,000 x 10%), you would receive only $500 ($10,000 x 5%).

Inflation Rate Risk

One of the reasons interest rates rise or fall is based on the expected inflation rate. Inflation rate risk is the chance that the cash flows from an investment would be worth less in the future because of changes in the purchasing power due to inflation. We know a $100 bill, 75 years ago, could buy a lot more goods (like hamburgers, soda and movie tickets) than the same $100 bill today. Well, high inflation can erode your income because the $500 in annual interest you receive is fixed, it does not change. With high inflation, $500 in years 18 & 19 will buy you much less than the same $500 in years 2 & 3. Expected inflation must be considered before the interest rate is set. If high inflation is expected, the interest rate needs to be set higher to compensate.

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