When dealing with investments and loans, it is important for all parties to fully understand the kinds of risk that accompany certain financial decisions. Risk accompanies most financial decisions, particularly in investment circles, and though it is an organic part of such acts, individuals should strive to research and comprehend the implications of such risks.
Those who deal with bonds have a few specific kinds of risk they must face. Two of the most prominent kids are interest rate risk and credit risk. Dealing with bonds can prove to be lucrative for individuals, but it is important to navigate this space with caution and precious to minimize losses.
Interest Rate Risk
The relationship between asset value and interest rate when it comes to bonds is inverse, meaning that when interest rates rise, the asset’s value decreases. Short-term bonds are less susceptible to significant fluctuations, and while long-term bonds present a greater opportunity for profit, they also have a much higher interest rate risk. High-risk bonds will perform well when interest rates drop.
Interest rate risk is also regarded as market risk, as a decrease in value when interest rates rise makes it difficult to sell.
Another type of risk facing those who invest in bonds is credit risk. This kind of risk is characterized by the possibility that investors may not get their promised principal and interest due to the potential of default. When you loan someone money or invest in bonds, you must accept the risk that your investment, as well as any profits you make, may not be paid in full. Most U.S. Treasury securities are at a low risk of defaulting, but that does not mean the risk is null.
If a bond defaults, investors may not receive their funds as early as promised, and they may also receive a smaller amount than expected. The worst scenario would entail investors not receiving any money at all.
Risk accompanies all investments, and without risk, there would be little chance for success and profit. Still, it pays to be conscious of the different kinds of risks investors can face when dealing with bonds. Bond issuers, for example, may offer higher interest rates to entice investors and compel them to accept the risks associated with their bonds. Staying informed and aware of the nature of the bond market can help investors take calculated risks and minimize the risk of losing money.