6 months of in-depth learning + 6 months of personalized guidance, mentorship! KNOW MORE

Debt Markets

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:

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. 

Did you like this unit?

Units 7/12