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Almost all investments have some level of risks. Trading securities can, involve high risk and the loss of any fund invested. It’s thus vital to bear in mind when investing in bonds that, an investment’s return is linked to its risk. Equally, relatively safe investments offer relatively lower returns.
Risks of investing in bonds
All investments offer a balance between risk and potential return. The risk is the chance that you will lose some or all the money you invest. The return is the money you stand to make on the investment.
The balance between risk and return varies by the type of investment, the entity that issues it, the state of the economy and the cycle of the securities markets. As a general rule, to earn the higher returns, you have to take greater risk. Conversely, the least risky investments also have the lowest returns. The choice is yours!
The bond market is no exception to this rule. Bonds in general are considered less risky than stocks for several reasons:
Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer.
Most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these payments to shareholders.
Historically the bond market has been less vulnerable to price swings or volatility than the stock market.
"Risk less" treasury yields
Bonds issued by the BNR are backed by the full faith and credit of the Rwanda government and therefore considered to have no credit risk. This means that there are always investors willing to buy NBR bonds thus; the forces of many buyers drive the prices down. Treasury yields will almost always be lower than other bonds with comparable maturities because they have the fewest risks.
Callable bonds are riskier than non-callable bonds, for example, and therefore offer a higher yield, particularly if the call date is soon and interest rates have declined since the bond was issued, making it more likely to be called.
Short-term bonds with maturities of three years or less will usually have lower yields than long-term bonds with maturities of 10 years or more, which are more susceptible to interest rate risk. All bonds have more risk when interest rates are rising, but those with the lowest coupons stand to lose the most value.
Bonds have a role to play in virtually every investor’s portfolio. Before you invest, however, you need to understand these risks of bond investments.
Risks of investing in all types of bonds: Government, Corporate and others.
Interest rate risk when interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. The longer the time to a bond’s maturity, the greater its interest rate risks.
Reinvestment risk When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates.
Inflation risk Inflation causes tomorrow’s FRW to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as "cash flows." Inflation also leads to higher interest rates, which in turn leads to lower bond prices.
Market risk The risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics.
Selection risk The risk that an investor chooses a security that underperforms the market for reasons that cannot be anticipated.
Timing risk The risk that an investment performs poorly after its purchase or better after its sale.
Risk that you paid too much for the transaction The risk that the costs and fees associated with an investment are excessive and detract too much from an investor’s return.
Legislative risk: The risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.
Liquidity risk The risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value. Liquidity risk is greater for thinly traded securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid during the period right after issuance when the typical bond has the highest trading volume.
Default risk: The possibility that a bond issuer will be unable to make interest or principal payments when they are due. If these payments are not made according to the agreements in the bond documentation (prospectus), the issuer can default. This risk is minimal for mortgage-backed securities issued by government agencies or government-sponsored enterprises—also known as "agency—and most asset-backed securities, which tend to carry bond insurance that guarantees payments of interest and principal to investors.
Event risk: The risk that a bond’s issuer undertakes a leveraged buyout, debt restructuring, merger or recapitalization that increases its debt load, causing its bonds’ values to fall, or interferes with its ability to make timely payments of interest and principal. Event risk can also occur due to natural or industrial accidents or regulatory change.
Nonetheless, responsible authorities occasionally, endeavour to suggest some mitigating factors for some risks.