Glossary For Investment Risk
When recommending securities to our clients, we consider various factors. Among those are the client’s financial holdings, risk tolerance, investment objectives, and related risk factors. Here we outline some of the key risk factors one should consider when investing in fixed income securities.
Business Risk – Business risk is the possibility that a particular enterprise will not do well- it may, for example, suffer from poor management, or increased competition. This is also referred to as credit risk.
Market Risk – Fixed Income is also subject to the risk of market as a whole. When the market suffers a large, general decline, all fixed income is affected.
Interest-Rate Risk – Investors who purchase bonds run the risk that the market value of their investments may decline if interest rates rise. This is called interest rate risk. Other investors will not be interested in purchasing existing bonds at par since they can get higher yields by purchasing new issues. Existing bonds will have to be sold at a discount in order to attract purchasers.
A bond portfolio may be diversified by investing in bonds from different issuers and with different coupon rates, maturity dates, and geographic locations. This strategy will provide protection against some risk, but not against interest-rate risk. Interest -rate risk systematic for bonds. All bonds have some exposure to interest-rate risk.
Bonds with longer maturities tend to be more vulnerable to interest-rate risk than bonds with shorter maturity, as do zero-coupon bonds. Bonds paying lower interest rates also tend to more sensitive to interest-rate risk when compared to similar maturing bonds with higher coupon rates.
Duration or Modified Duration – Duration is a means of measuring a bond’s sensitivity to interest-rate risk. An Increase or decrease in interest rates will have an inverse effect on bond prices. Duration measures the percentage change in the market value of a bond given a small change in interest rates. The longer the bonds duration, the more vulnerable it is to interest-rate risk.
Duration allows for the comparison of interest-rate risk among securities with different coupons, maturities, and credit quality. Longer maturities and lower coupon rates and yields all create higher durations. Bonds with duration of one to three years have minimal interest-rate risk and are considered conservative. Those with durations of four to seven years have moderate interest-rate risk. Those with durations of longer than seven years have greater interest-rate risk.
Reinvestment Risk – This is the risk an investor will not be able to reinvest her principal at the same interest rate after a bond matures or is called. This situation typically occurs when interest rates are falling. The investor usually has two choices- accept a lower rate of return, or assume a higher degree of risk to keep her returns stable
Inflation Risk – Inflation is a general rise in the cost of goods and services, as measured by the Consumer Price Index (CPI). Inflation diminishes the real value of a dollar by decreasing its purchasing power (which is why inflation risk is also called purchasing power risk).
Fixed-income securities are more vulnerable to inflation. Inflation represents a double whammy for bondholders- interest rates rise causing the market price of their holdings to fall while the purchasing power of their interest payments also decreases.
However, there are fixed-income securities that are especially designed to address this problem. Treasury Inflation-Protected Securities (TIPS) are example of these inflation-linked bonds. Like all securities issued by the treasury department, TIPS are currently offered in 5-year, 10-year, and 20-year maturities.
TIPS pay a fixed rate of interest semiannually, but the principal of each bond is automatically adjusted upward or downward based on the changes in the Consumer Price Index. The semiannual interest payments are them calculated based on the adjusted principal. The investor receives the adjusted principal or the original principal upon maturity, whichever is greater.
Regulatory Risk – Regulatory risk (also called legislative risk) is the possibility that new laws or regulations may have a negative impact on the investment value. Changes in the law can occur at any level of government at any level of government and can potentially affect all sorts of investments.
Liquidity Risk – Liquidity risk is the risk that investors will not be able to dispose of a securities position quickly and at a price related to recent transactions. This type of risk tends to increase as the amount of trading in a particular security decreases.
Opportunity Risk – Investors who are planning to hold bonds until they mature may feel that they do not need to be concerned if a bond’s market price declines because of an increase in interest rates. After all, as long as the issuer does not default, they will receive the bond’s par value ones it matures. The problem with this perspective is that it does not take into account the higher interest that the investors might have earned in alternative investments, otherwise known as opportunity risk.
Relative Risk – Different classes of securities have inherently different risk. The safest securities would be short term U.S Treasury securities. In the corporate world liquidation priority would be given to secured debt, followed by general creditors and subordinate creditors. After debt, preferred stock would have a higher priority than common stock. Generally speaking the higher the liquidation priority, the less the relative risk.
Currency (Exchange-Rate) Risk – This is the possibility that the value of foreign investments will be worth less in the future due to variances in the exchange rates.
Exchange rates can be affected by the number of factors including interest rates. If interest rates in the United States are higher than interest rates overseas, foreign investors wishing to earn higher rates will want to invest in the United States. In order to do so, they must first convert their funds into dollars. As the demand for dollars increase, the exchange rate for dollars will increase. Thus higher U.S interest rates compared to foreign yields will lead to a stronger dollar.
The opposite may occur if interest rates in the European Union, Japan or other developed countries are higher than U.S rates
If the dollar is strengthening against foreign currencies, then U.S goods and services will become more expensive for foreigners. This should result in an increase in the importation of foreign goods into the United States and a decrease in the exportation of U.S goods to other countries. As a result the U.S balance of trade will worsen and the trade will increase.
A weakening dollar should produce the opposite effect. U.S goods and services will become less expensive for foreigners, causing exports to increase and imports to decrease. Thus, a weakening dollar will have a positive impact on the U.S balance of trade and trade deficit.
Complexity Risk – This is the risk associated with using different option strategies, such as buying and writing multiple options in combination, or buying or writing options in combination with buying or selling short the underlying securities. Combination transactions are more complex than buying or writing a single option and present additional risk for investors.