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In general the bond market is volatile, and fixed income securities carry interest rate risk. Investments are subject to investment risks including the possible loss of the principal amount invested. Bond investments may be subject, but not limited, to the following investment risks:
Credit and default risk – Corporate bonds are subject to credit risk. It’s important to pay attention to changes in the credit quality of the issuer, as less creditworthy issuers may be more likely to default on interest payments or principal repayment. If a bond issuer fails to make either a coupon or principal payment when they are due, or fails to meet some other provision of the bond indenture, it is said to be in default.
Market risk – Price volatility of corporate bonds increases with the length of the maturity and decreases as the size of the coupon increases. Changes in credit rating can also affect prices. If one of the major rating services lowers its credit rating for a particular issue, the price of that security usually declines.
Event risk – A bond’s payments are dependent on the issuer’s ability to generate cash flow. Unforeseen events could impact their ability to meet those commitments.
Call risk – Many corporate bonds are callable, which means they can be redeemed or paid off at the issuer’s discretion prior to maturity. Typically an issuer will call a bond when interest rates fall below the coupon rate potentially leaving investors with a loss in income and less favorable reinvestment options. Prior to purchasing a corporate bond, determine whether call provisions exist. An investors should ensure that the yield he/she is quoted includes the yield to the worst case in the event of a call.
Sector risk – Corporate bond issuers fall into four main sectors: industrial, financial, utilities, and transportation. Bonds in these economic sectors can be affected by a range of factors, including corporate events, consumer demand, changes in the economic cycle, changes in regulation, interest rate and commodity volatility, changes in overseas economic conditions, and currency fluctuations. Understanding the degree to which each sector can be influenced by these factors is the first step toward building a diversified bond portfolio.
Interest rate risk – If interest rates rise, the price of existing bonds usually declines. That’s because new bonds are likely to be issued with higher yields as interest rates increase, making the old or outstanding bonds less attractive. If interest rates decline, however, bond prices usually increase, which means an investor can sometimes sell a bond for more than they paid or a premium to face value, since other investors are willing to pay a premium for a bond with a higher interest payment. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you’re holding a bond until maturity, interest rate risk is not a concern.
Government securities risk – The U.S. Treasury only backs in full all some obligations of the U.S. government, its agencies and instrumentalities. Some obligations are backed only by the credit of the issuing agency or instrumentality, and in some cases there may be some risk of default by the issuer. The U.S. government or its agencies or instrumentalities cannot guarantee the market value of a security, only the timely payment of interest and principal when held to maturity. U.S government securities may increase or decrease in value based on global demand and changes in global economic conditions affect the demand for these securities.
Municipal securities risk – Public information available about municipal securities is in general limited and less available than that for corporate equities or bonds. Special factors, such as legislative changes, and state and local economic and business developments, may adversely affect the yield and/or value of the bond investments in municipal securities. Investments in municipal projects of a municipality or a state may impact the bond”s value, if economic, business or political conditions change for the municipality or state.
Foreign risk – In addition to the risks mentioned above, there are additional considerations for bonds issued by foreign governments and corporations. These bonds can experience greater volatility, due to increased political, regulatory, market, or economic risks. These risks are usually more pronounced in emerging markets.
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