Companies issue bonds to finance large projects and operations. The United States Government, on the other hand, issues bonds to finance infrastructure and debt repayment, among other government spending.
Bonds are debt instruments sold to private and institutional investors on markets like the US Treasury Security Market. When you buy a bond, you essentially lend money to the government or a company. After the bond matures, you get back your principal plus interest.
Bonds, especially corporate bonds, come with several other risks, and a self-assessment of your risk disposition helps you determine how much risk you are willing to take when investing in bonds. Credit risk implies that the issuer may default before the bond matures. If that happens, you may lose some or all of the interest and principal.
In bond investing, you could face a liquidity risk. This arises in a narrow market when it becomes difficult to sell bonds because there are few buyers and sellers. To measure bond risk, independent entities, such as Standard & Poor's (S&P) and Moody's, rate bonds. The rating indicates the bond's credit quality and worthiness. The better the rating, the less likely the issuer will default. Ratings range from AAA for high-grade bonds very likely to be repaid to D for defaulted bonds.
However, the ratings do not account for all the risks associated with particular bonds. After you purchase a bond, new risks could emerge. For example, if a bond issuer decides to restructure or acquire another asset, the issuer's debt burden will increase. This may affect the bond issuer's ability to service the existing bond liability, which increases that bond's risk and may reduce its price.
Low buyer interest may also affect a particular bond's price, impacting your income should you sell. When investing, the price could be much lower than expected, leading to potential loss.
In some cases, bond rating agencies may update the issuer's credit profile late. For example, it may take some time for a company to be downgraded as the symptoms of financial strain might be gradual and not visible in the short term. In such a case, the value of your holdings might not reflect its true worth.
Additional features like the "call option" can also expose new risks. Through the call option, the bond issuer can buy back the bonds before they reach maturity after a specified period mentioned in the company prospectus. In an environment of declining interest rates, this could work against you. If the interest rate falls, you are entitled to the earlier fixed rate, which may be higher than the current market rate. The bond issuer may, therefore, decide to invoke the call option and buy back the high-paying bonds. The issuer can even issue new bonds at a lower rate.
An additional downside of a bond call option is that you may be left with liquid cash that you cannot reinvest at a comparable rate. Also known as reinvestment risk, it may impact your long-term investment goal. The call action may even force you to restructure your overall investment portfolio to counter its effects.
