The Risks of Bond Investing: Understanding Dangers in Fixed-Income Investing

There's no such thing as a sure thing, even in the bond world

From Paul Conley, former About.com Guide

Bonds are among the safest investments in the world. But that hardly means that they’re risk free. Here’s a look at some of the dangers inherent in fixed-income investing.

• Inflation Risk: Because of their relative safety, bonds tend not to offer extraordinarily high returns. That makes them particularly vulnerable when inflation rises.
  Imagine, for example, that you buy a Treasury bond that pays interest of 3.32%. That’s about as safe an investment as you can find. As long as you hold the bond until maturity and the U.S. government doesn’t collapse, nothing can go wrong….unless inflation climbs. If the rate of inflation rises to, say, 4 percent, your investment is not “keeping up with inflation.” In fact, you’d be “losing” money because the value of the cash you invested in the bond is declining. You’ll get your principal back when the bond matures, but it will be worth less.
  Note: there are exceptions to this rule. For example, the Treasury Department also sells an investment vehicle called Treasury Inflation-Protected Securities.
• Interest rate risk: Bond prices have an inverse relationship to interest rates. When one rises, the other falls.
  If you have to sell a bond before it matures, the price you can fetch will be based on the interest rate environment at the time of the sale. In other words, if rates have risen since you “locked in” your return, the price of the security will fall.
  All bonds fluctuate with interest rates. Calculating the vulnerability of any individual bond to a rate shift involves an enormously complex concept called duration. But average investors need to know only two things about interest rate risk.
  First, if you hold a security until maturity, interest rate risk is not a factor. You’ll get back the entire principal upon maturity.
  Second, zero-coupon investments, which make all their interest payments when the bond matures, are the most vulnerable to interest rate swings.
• Default Risk: A bond is nothing more than a promise to repay the debt holder. And promises are made to be broken. Corporations go bankrupt. Cities and states default on muni bonds. Things happen...and default is the worst thing that can happen to a bondholder.
  There are two things to remember about default risk.
  First, you don’t need to weigh the risk yourself. Credit ratings agencies such as Moody’s do that. In fact, bond credit ratings are nothing more than a default scale. Junk bonds, which have the highest default risk, are at the bottom of the scale. Aaa rated corporate debt, where default is seen as extremely unlikely, is at the top.
  Second, if you’re buying U.S. government debt, your default risk is nonexistent. The debt issues sold by the Treasury Department are guaranteed by the full faith and credit of the federal government. It’s inconceivable that the folks who actually print the money will default on their debt.
• Downgrade Risk: Sometimes you buy a bond with a high rating, only to find that Wall Street later sours on the issue. That’s downgrade risk.
  If the credit rating agencies such as Standard & Poor’s and Moody’s lower their ratings on a bond, the price of those bonds will fall. That can hurt an investor who has to sell a bond before maturity. And downgrade risk is complicated by the next item on the list, liquidity risk.
• Liquidity risk: The market for bonds is considerable thinner than for stock. The simple truth is that when a bond is sold on the secondary market, there’s not always a buyer. Liquidity risk describes the danger that when you need to sell a bond, you won’t be able to.
  Liquidity risk is nonexistent for government debt. And shares in a bond fund can always be sold.
  But if you hold any other type of debt, you may find it difficult to sell.
• Reinvestment Risk: Many corporate bonds are callable. What that means is that the bond issuer reserves the right to “call” the bond before maturity and pay off the debt. That can lead to reinvestment risk.
  Issuers tend to call bonds when interest rates fall. That can be a disaster for an investor who thought he had locked in an interest rate and a level of safety.
  For example, suppose you had a nice, safe Aaa-rated corporate bond that paid you 4% a year. Then rates fall to $2%. Your bond gets called. You’ll get back your principal, but you won’t be able to find a new, comparable bond in which to invest that principal. If rates have fallen to 2%, you’re not going to get 4% with a nice, safe new Aaa-rated bond.
• Rip-off Risk: Finally, in the bond market there’s always the risk of getting ripped off. Unlike the stock market, where prices and transactions are transparent, most of the bond market remains a dark hole.
  There are exceptions. And average investors should stick to doing business in those areas. For example, the bond fund world is pretty transparent. It only takes a tiny bit of research to determine if there is a load (sales commission) on a fund. And it only takes another few seconds to determine if that load is something you’re willing to pay.
  Buying government debt is a low-risk activity as long as you deal with the government itself or some other reputable institution. Even buying new issues of corporate or muni debt isn’t all that bad.
  But the secondary market for individual bonds is no place for smaller investors. Things are better than they once were. The TRACE (Trade Reporting and Compliance Engine) system has done wonders to provide individual bond investors with the information they need to make informed investing decisions.
  But you’d be hard-pressed to find any scrupulous financial advisor who would recommend that your average investor venture in to the secondary market on his own.
  
  
  http://bonds.about.com/od/bonds101/a/bondrisk.htm

Liquidity Risk

Understanding Liquidity Risk and Your Investments

By Joshua Kennon, About.com Guide

As a new investor, you are going to come across the term "liquidity risk". It is important you understand what liquidity risk is and why it is important because it could pose a significant threat to your financial well-being unless you protect against it. Although I've explained how some investors strive to pay off their home mortgage debt early but find themselves bankrupt due to the liquidity crunch they created for their household, I wanted to stop to talk about the specifics of how liquidity risk can attack you in other, unexpected ways.

Liquidity Risk - The Short Version

In the simplest terms, liquidity risk refers to the risk that an investment won't have an active buyer or seller when you are ready to buy or sell it. This means you will be stuck holding the investment at a time when you need cash. In extreme cases, liquidity risk can cause you to take huge losses because you have to mark down your property at fire sale prices to attract buyers.

One of the reasons for the losses suffered by financial firms during the Great Recession was the fact that these companies owned illiquid securities. When they found themselves without enough cash to pay the day-to-day bills, they went to sell these assets but discovered that the market had dried up completely. As a result, they had to sell at any price they could get - sometimes as low as pennies on the dollar!

The most famous case is Lehman Brothers, which was financed with too much short-term money. The management foolishly used this short-term money to buy long-term investments that weren't liquid - or rather, assets thst became illiquid after the meltdown. When the short-term money was withdrawn, the firm couldn't come up with the cash because they couldn't sell the long-term, illiquid securities fast enough to meet obligations. The stockholders were nearly wiped out despite the fact that Lehman was profitable and had a multi-billion dollar net worth.

On the upside, there is opportunity with liquidity risk because other companies and investors that were flush with cash were able to buy distressed assets. Some of these "vulture" investors made a killing because they had balance sheets that could support holding non-liquid investments for long periods of time.

To compensate for liquidity risks, investors often demand a higher rate of return on money invested in illiquid assets. That is, a small business can't be easily sold in most cases so investors are likely to demand a higher rate of return for investing in shares of it than they would a highly liquid blue chip stock. Likewise, investors require a much smaller return for parking money in the bank.

Liquidity Risk - The Long Version

There are several different types of liquidity risk but I'm only going to teach you about the three major ones that are likely to afflict regular investors.

• Liquidity Risk #1 - Bid/Offer Spread Widening - When an emergency hits the market or an individual investment, you may see the bid and ask spread blow apart so that the market maker has a difficult time matching up buyers and sellers. That is, your shares of Company XYZ stock may have a current market price of $20 but the bid may have fallen to $14 so you can't actually get the $20 you want! You often see very large ask / big spreads in thinly traded stocks and bonds, whereas huge, liquid blue chip stocks often have spreads as low as a penny or two.
• Liquidity Risk #2 - Inability to Meet Cash Obligations When Payment Is Due - This is the investment equivalent of defaulting on a debt. If a company has $100 million in bonds that reach maturity, it is expected to pay off the entire $100 million balance by the maturity date. Most of the time, businesses refinance this debt. But what happens if the debt markets aren't working, like during the Great Recession when the credit crunch made it impossible to borrow money? In that case, if the company couldn't come up with the whole $100 million, it could be hurled directly into bankruptcy court even if it is highly profitable. You would find yourself locked into what could be years of court workouts due to the firm mismanaging its liquidity risk.
• Liquidity Risk #3 - Inability to Meet Funding Needs at an Affordable Price - This is when it is impossible for a company or other investment to raise enough money to function properly and meet its needs at a price that is economical. Wal-Mart Stores, Inc., for example, is one of the biggest and most profitable companies on the planet. It has tens of billions of dollars in debt in order to optimize the company's capitalization structure. If the markets went haywire tomorrow and Wal-Mart could no longer borrow at 6% and investors instead demanded 30%, it would make no sense for the company to issue bonds. In effect, the market's liquidity would have dried up completely and the stockholders of Wal-Mart would have to worry about the company coming up with enough cash to wipe out all of its debt.

Protecting Yourself Again Liquidity Risk

There are several ways you can help protect yourself from liquidity risk. These include:

• Never buy long-term investments that are illiquid unless you can afford to hold them through terrible recessions and job loss. If you might need cash in six months, don't buy 5-year certificate of deposits or an apartment building.
• Remember that your total debt is less important as the amount of excess cash you have after making your debt payments each month. Fixed payments of $5,000 per month are overwhelming to someone with $6,000 per month in take-home pay. The same payments are a rounding error to someone making $300,000 per month. All else being equal, the bigger the cushion between the cash you earn each month and the cash you pay out, the less the chance you get caught in a liquidity risk crisis.
• Avoid investing in companies that are facing potential liquidity risk. Is there any big debt refinancing plans that could risk the company's well-being? Does the company have a solid balance sheet with long-term funding sources, such as shareholder equity instead of short-term deposits? If you don't understand what this means, you should probably stick to low-cost, widely diversified index funds.

http://beginnersinvest.about.com/od/Risk-Management/a/Liquidity-Risk-101.htm

The 3 Types of Investment Risk

The 3 Types of Investment Risk
The Basics of Risk Management 
 By Joshua Kennon, About.com Guide

Smart investing includes risk management. For each stock, bond, mutual fund or other investment you purchase, there are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk. In this article, we are going to examine each type and discover ways you can protect yourself from financial disaster.

Investment Risk #1: Business Risk

Business risk is, perhaps, the most familiar and easily understood. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk (think airlines, railroads, steel, etc).

The biggest defense against business risk is the presence of franchise value. Companies that possess franchise value are able to raise prices to adjust for increased labor, taxes or material costs. The stocks and bonds of commodity-type businessesdo not have this luxury and normally decline significantly when the economic environment turns south.

Investment Risk #2: Valuation Risk

Recently, I found a company I absolutely love (said company will remain nameless). The margins are excellent, growth is stellar, there is little or no debt on the balance sheet and the brand is expanding into a number of new markets. However, the business is trading at a price that is so far in excess of it's current and average earnings, I cannot possibly justify purchasing the stock.

Why? I'm not concerned about business risk. Instead, I am concerned about valuation risk. In order to justify the purchase of the stock at this sky-high price, I have to be absolutely certain that the future growth prospects will increase my earnings yield to a more attractive level than all of the other investments at my disposal.

The danger of investing in companies that appear overvalued is that there is normally little room for error. The business may indeed be wonderful, but if it experiences a significant sales decline in one quarter or does not open new locations as rapidly as it originally projected, the stock will decline significantly. This is a throw-back to our basic principle that an investor should never ask "Is company ABC a good investment"; instead, he should ask, "Is company ABC a good investment at this price."

Investment Risk #3: Force of Sale Risk

You've done everything right and found an excellent company that is selling far below what it is really worth, buying a good number of shares. It's January, and you plan on using the stock to pay your April tax bill.

By putting yourself in this position, you have bet onwhen your stock is going to appreciate. This is a financially fatal mistake. In the stock market, you can be relatively certain of what will happen, but not when. You have turned your basic advantage (the luxury of holding permanently and ignoring market quotations), into a disadvantage.

Consider the following: If you had purchased shares of great companies such as Coca-Cola, Berkshire Hathaway, Gillette and Washington Post at a decent price in 1987 yet had to sell the stock sometime later in the year, you would have been devastated by the crash that occurred in October. Your investment analysis may have been absolutely correct but because you imposed a time limit, you opened yourself up to a tremendous amount of risk.

Being forced to sell your investments is really something known as liquidity risk, which is important enough I wrote a separate article about it to help you understand why it poses such a threat to your net worth.

The Moral

There is always some degree present in every investment you purchase. At the same time, by avoiding or minimizing specific types of risk, you can keep temporary hiccups in the economy or financial markets from destroying your wealth.


http://beginnersinvest.about.com/cs/valueinvesting1/a/080103a.htm

The Investor and Market Fluctuations: Stock Market Equity Ownership has the important attribute of Liquidity (6)

Critics of the value approach to stock investment argue that listed common stocks cannot properly be regarded or appraised in the same way as an interest in a similar private enterprise, because the presence of an organized security market “injects into equity ownership the new and extremely important attribute of liquidity.”

But what this liquidity really means is, 

• first, that the investor has the benefit of the stock market’s daily and changing appraisal of his holdings, for whatever that appraisal may be worth, and, 
• second, that the investor is able to increase or decrease his investment at the market’s daily figure—if he chooses. 

Thus the existence of a quoted market gives the investor  certain options that he does not have if his security is unquoted.

But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source.