Why bonds are considered a safer investment than commodities or shares
Since bonds usually have a fixed interest rate, which accounts for the largest part of the return, they are generally considered safer than participating investments, i.e. shares. This is because shares and commodities do not have redemption dates and are therefore much more subject to market fluctuations than bonds.
The following risks may be distinguished regarding bonds:
- Price risk: effects of a change in market interest rates on the bond price;
- Credit risk of the bond issuer;
- Currency risk (only for foreign currency bonds);
- Liquidity risk;
- Call risk.
7 Good arguments for corporate bonds. Our free information brochure offers you valuable insights for this special asset class.
A Corporate Bond sample portfolio : Interest rate calendar as an orientation.
The first risk with bonds: Price risk
Bond prices are highly dependent on changes in market interest rates. While the bond issuer always repays the bond at 100 per cent of the nominal value at the expiry of the term, the market interest rate can influence the bond price in one direction or the other during that term. The value of the bond decreases when the interest rate increases. This is because investors can invest the repayment amounts (coupon and redemption) at the new, more attractive interest rate. The change in price and the change in yield are therefore opposite.
All bonds have price fluctuations. This is relevant for investors who need to sell their bonds before maturity or speculate on price gains. If the market interest rate rises sharply, the bond price may fall below the nominal value of 100 per cent, i.e., below par. If the investor then has to sell, he theoretically makes a loss. However, since redemption takes place at par, such losses are of no further significance for investors who hold the bond until final maturity.
The second risk: Credit risk of the bond issuer
The issuer’s credit risk is also called creditworthiness risk or default risk. It arises if the issuer of a bond defaults on payments or even becomes insolvent. For the investor, this can mean a partial or total loss of the invested capital. Thus, the issuer’s creditworthiness is the most important criterion for the investor and subsequent creditor when making an investment decision. A good credit rating should ensure that the bond issuer fulfils its contractual obligations.
However, a high credit rating is no guarantee because the credit rating can change over the years during the bond term due to a new business circumstance or political situation. Political causes for changes in creditworthiness can be elections, for example, but macroeconomic changes or company-specific factors can also influence creditworthiness.
The credit risk of bonds can also be measured by the difference (spread) between the valuation of government bonds on the one hand and the valuation of e.g. corporate bonds on the other. See graph below.
This chart shows that euro investment grade bond spreads are trading well above their lows.
To assess such changes in creditworthiness, private investors have access to the analyses of rating agencies. The three largest and best-known agencies are Moody’s, Standard & Poor’s, and Fitch. The analyses of the rating agencies are based on the information of the companies to be analysed and are therefore carried out “ex-post”, i.e., with a time lag. Therefore, the credit rating should only be one criterion in the investment decision.
The 3rd risk of bonds: Currency risk
In the case of bonds denominated in a foreign currency (e.g., US dollar or pound sterling), risks or opportunities may arise due to the exchange rate fluctuations of the foreign currency against the euro. If you hold a US dollar bond with interest paid in US dollars, then the interest credited in euros will increase in value if the dollar goes up against the euro. An additional profit can also be made when the bond is redeemed if the dollar exchange rate is higher at redemption than when the bond was purchased (since you get more euros for the same amount of dollars). Otherwise, however, there can also be currency losses in the same way. Therefore, this uncertainty is considered a risk. Read more about US BONDS here (Link).
The exchange rates Dollar versus EURO over the past 10 years
Liquidity risk
Liquidity risk refers to the risk that a bond cannot be sold to other investors or can only be sold at a high discount if money is needed before maturity. To minimise liquidity risk, it is advisable to acquire bonds that have already been placed and have a high issue volume.
The final risk of the bonds: The call risk
Many issuers grant themselves an early termination option in the bond terms and conditions to reduce the risk of permanently high-interest payments. This option is also known as a “call”. Amounts called in may only be reinvested at a then prevailing lower interest rate.
Risk and return
Overall, the basic rule for the risks of bonds is once again: the higher the interest rate and yield, the higher the risks of the bond investment (most probably).
“Again the old principle applies: the higher the return, the higher the risk”
Conclusion:
Genève-Invest has been focusing on high-yield institutional corporate bonds with the best risk/return ratio for over 20 years.
We seek to balance risk by analysing each company in depth and monitoring it constantly. We pay attention to seniority, redemption ratios, different maturities in the portfolio, the impact of market fluctuations and the protection that higher yields inherently offer. We also pay attention to maturity to protect our clients’ portfolios against inflation and potential interest rate increases.
If you would like to discuss the risk of investing in bonds in detail, you can arrange a personal meeting with one of our investment experts.
