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Advantages and Disadvantages of Bonds
Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures. However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
Disadvantages of Bonds
Bonds are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
LEARNING OBJECTIVE
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Discuss the disadvantages of owning a bond
KEY POINTS
- Abondis an instrument of indebtedness of the bondissuerto the holders. It is adebtsecurityunder which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay theminterestand possibly repay theprincipalat a later date, which is termed thematurity.
- Fixed rate bonds are subject tointerest raterisk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise.
- Bonds are also subject to various other risks such as call and prepayment risk,creditrisk,reinvestment risk,liquidityrisk, event risk,exchangeraterisk,volatilityrisk,inflationrisk, sovereign risk, andyieldcurverisk.
- A company's bondholders may lose much or all their money if the company goes bankrupt. There is no guarantee of how much money will remain to repay bondholders.
- Some bonds arecallable. This creates reinvestment risk, meaning theinvestoris forced to find a new place for his money. As a consequence, the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
TERMS
- Reinvestment risk
The reinvestment risk is the possibility that the investor might be forced to find a new place for his money. As a consequence, the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
- Exchange rate risk
The exchange rate risk is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies.
Definition and Purpose of a Bond
A bond is a debt owed by the enterprise to the bondholder. Commercial bonds are normally issued in units of 1,000 dollars. Bondholders receive regular interest on theirinvestment, depending on the terms of the bond. As a safe security, bonds are widely bought and traded by financial institutions. However, bonds have certain disadvantages.
Bond: A bond is a debt owned by the enterprise to the bondholder.
Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting the ability of investors to get a higher interest rate on their money elsewhere - perhaps by purchasing a newly issued bond that already features the newly higher interest rate.
Disadvantages of Bonds
Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.
Price changes in a bond will immediately affectmutual fundsthat hold these bonds. If the value of the bonds in a tradingportfoliofalls, the value of the portfolio also falls. This can be damaging for professional investors such asbanks, insurance companies,pension funds, andassetmanagers (irrespective of whether the value is immediately "marked to market" or not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", the interest rate risk could become a real problem.
Bond prices can become volatile depending on thecredit ratingof the issuer – for instance ifcredit rating agencieslike Standard and Poor's and Moody's upgrade or downgrade the credit rating of the issuer. An unanticipated downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of thesaleof the assets of aliquidatedcompany ahead of some othercreditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence. There is no guarantee of how much money will remain to repay bondholders. In abankruptcyinvolving reorganization orrecapitalization, as opposed toliquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.
Some bonds are callable, meaning that even though the company has agreed to make payments plus interest toward the debt for a certainperiodof time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money. As a consequence, the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
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