Types Of Risk Associated With A Bond
When buying a bond, we should look at the various risks it carries. Generally, there are 2 types of risks involved. Credit Risk and Interest Rate Risk.
Credit Risk is the risk which explains that a borrower may fail to make timely payments of interest or principal that he previously borrowed. Credit Risk has 2 components:
A. Default Risk:
Default risk is the probability that a bond issuer or a borrower will fail to repay principal or interest when due.
B. Loss Severity:
Loss Given Default or Loss Severity is the actual amount an investor will lose if the company defaults. For example, if the default risk is 40% and the amount that you invest was ₹100, your loss severity will be 40%*₹100 = ₹40.
Interest Rate Risk:
When the Interest Rate of a debt instrument rises, its value decreases, which leads to a loss for its holder. Interest Rate Risk is the risk that a bondholder will face severe losses if the interest rates rise in the future. For example, if the interest rate of a bond rises then the market value of that bond will decrease, which will lead to a loss.
The Interest Rate of a Bond and its price are inversely related, i.e., when the interest rate rises, a bond’s Present Value (PV) decreases and vice-versa. This is because when the interest rates rise, all the future cash flows of that bond are discounted at a higher rate which leads to its PV being lower and vice-versa.
Diversifying our investments in bonds that have different duration can reduce interest rate risk.
We will discuss the concept of duration in the next section.