Delving into the world of investments can be a daunting one for the less experienced investor. One of the first questions persons often ask themselves is "What should I invest in?" That question is often accompanied by a series of other questions including those that would assist them in determining the various risks involved.
New investors may want to start investing in less risky assets such as fixed income investments which include bonds, treasury bills and fixed deposits. Fixed income instruments are investments which provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. The fixed periodic payments are interest payments or coupon payments.
While these investments are generally considered to be more conservative and less risky than equity investments, bonds and other fixed income investments do still carry a variety of risks that investors must be aware of.
In this article, we examine three of the risks inherent to fixed income investments; credit risk, interest rate risk and liquidity risk.
Credit risk
Also known as default risk, this is the risk of loss resulting from the issuer/borrower failing to make full and timely payments of interest and/ or principal. When assessing a bond, it is important to consider both the probability of default and the portion of a bond's value that may be lost in the event of a default.
Realising its importance, institutions known as credit rating agencies conduct objective and independent assessments of countries, companies and securities, assigning a credit rating. The ratings provide investors with information that assists them in determining the likelihood of issuers of debt obligations being able to make the scheduled payments on time. Some of the better known international credit rating agencies include Standard and Poor's, Moody's and Fitch.
Standard and Poor's ratings, for example, range from AAA (the most secure/highest credit quality) to D, which means the issuer has already defaulted. T&T has been assigned an A rating.
Bonds are classified as either investment grade or non-investment grade (commonly referred to as junk or high yield bonds).
While investment grade bonds are generally deemed to be less risky, with a greater promise of repayment, these bonds tend to have a lower yield than the non-investment grade bonds which must pay a higher rate of interest to compensate for
Here we see a principle being introduced known as the risk-return tradeoff, which states that potential return rises with increased risk.
Interest rate risk
Interest rate risk is the risk that an investment's value will decline due to rising interest rates. As interest rates change, the yield on most bonds are adjusted accordingly. There exists an inverse relationship between interest rates and the price of a bond, ie as interest rates fall, the price of a bond rises. Conversely, as interest rates rise, the bond price falls.
To illustrate this: let's suppose you bought a $1,000 par value bond with a three-year maturity and a 2.5 per cent coupon rate. You will therefore earn $25 each year that you own the bond.
Let's further assume that after one year, you decide to sell the bond, and that new bonds with similar characteristics are now being issued with 5.0 per cent coupons. To encourage persons to buy your bond, you will have to discount its price, since investors are now able to invest their $1,000 in a bond that pays them more; $50 per year. If a bond is being held until maturity, interest rate risk is less of a concern for investors.
Liquidity risk
To better understand liquidity risk, think of a car that you own, but wish to sell. If several individuals are interested in purchasing the vehicle, there is a high possibility that you will be able to sell the vehicle at a price that is reflective of its market value. If however, there are little to no potential buyers, you may be forced to lower the price, possibly incurring a loss, to attract buyers and ultimately, sell the vehicle. The same principle applies for bonds.
Liquidity risk is the risk of being unable to buy or sell investments quickly for a price that is reflective of its true value. When a bond is said to be liquid, there generally exists an active market of investors buying and selling the bond.
Government bonds and larger issues by well-known corporations are typically very liquid. Some bonds are however illiquid and trade very infrequently, which can present a problem if trying to sell before maturity.
In general, a bond with greater frequency of trading and a higher volume of trading provides fixed income investors with more opportunity to purchase or sell the security and thus has less liquidity risk. Three main factors that can affect liquidity risk are the size of the issue, the frequency with which the issuer issues bonds and the credit quality of the issuer. Generally, issues that are smaller in size have less trades and consequently, higher liquidity risk.
Additionally, the lower the credit quality of the issuer, the higher the liquidity risk. Unexpected downgrades of credit ratings on corporate bonds can result in increased credit and liquidity risk.
Conclusion
Diversification is an excellent means of minimising many of these risks inherent in fixed income securities. In the world of fixed income, diversification takes on many forms, and can be done based on bond type, bond issuer (such as government or corporate bonds; duration (short-, intermediate-, and long-term bonds), credit quality and industry.
Mutual funds offer an attractive alternative to building your own investment portfolio as they provide diversification and professional investment management at a lower initial investment. At the Unit Trust Corporation, we offer several mutual funds which cater to the diverse needs of the wider public. Fixed income investors should consider our TT Dollar Income Fund and US dollar Income Fund which give access to a diversified portfolio of fixed income securities.
For our corporate clients looking for fixed income investments, the UTC Corporate Fund is also an option. These mutual funds make the process of investing less daunting as they significantly reduce and even eliminate some of the risks faced by fixed income investors, including those mentioned above. Call or visit us for more information.