The risks of bonds

For bonds issued in foreign currencies, there is what is known as foreign exchange risk.

Fluctuations in exchange rates can affect bond performance when interest payments and repaid principal are converted into the investor’s domestic currency. This risk can add an additional layer of uncertainty to investing in foreign bonds.

For the Italian investor, and more generally for those in the Eurozone, bonds denominated in a currency other than the euro always carry a significantly higher riskiness than equivalent bonds (by type of rate, maturity, rating and seniority) denominated in the single currency, even when the residual life of the bond is relatively short (6 months and up).

Both the coupons and, more importantly, the redemption at maturity, or the sale proceeds in the case of early divestment, are in fact exposed to the risk of the foreign currency depreciating against the euro, gradually eroding the return on investment. Suffice it to say that even the most solid currency has annual volatility in the order of at least 7 percent against the euro.

The most heavily beaten currencies other than the euro in bond markets, displayed in order of increasing volatility of the relative exchange rate with the single currency, are:

1. The U.S. dollar and the British pound among the most important and least volatile, from an investment diversification perspective, characterized by a 7 percent share of annual volatility;
2. The Australian dollar, New Zealand dollar and Canadian dollar among the classic “commodity currencies” (i.e., major currencies linked to commodity trends), also beaten with a view to diversifying investments at appropriate market phases;
3. The Brazilian real, the South African rand, the ruble, the Turkish lira, and partially the Mexican peso among the high-yielding currencies, where exchange rate volatility is such that both the extra return over euro investments and the full return of capital at maturity translated into euros are normally in doubt.

Rate risk, also called market risk, is related to the Depreciation that a bond would experience if there were an increase in the current yield expressed by the market for similar securities also in terms of maturity, or rather duration, and, of course, currency: in such a circumstance, in fact, the descent of the price would be the only possible way to procure an increase in the yield of a fixed-rate (also step-up or step-down) or zero-coupon type bond, a descent that manifests itself all the more widely-as the market yield changes the same-the longer the duration of the bond.

As the remaining life of a bond, and thus its so-called modified duration, decreases with the passage of time, from the time when maturity (and thus the time of redemption) progressively approaches, the interest rate risk and the bond price will become progressively less sensitive to changes in the yields expressed by the market for similar bonds also in terms of maturity as well as currency.

For those who carry the bonds to maturity, the risk described does not turn into a real capital loss, but into an opportunity cost: in the event of an increase in market yield, the investor, by continuing to hold the bonds, will be content to receive lower proceeds than the returns offered at that time by the market.

Liquidity risk Is understood as greater or lesser ease of negotiating the bond quickly enough, for even large amounts and according to a bid-ask spread (or “bid-ask spread”) that is as narrow as possible: the greater the difference between price-letter (“ask,” i.e., the price at which it is possible to buy the security at the moment) and price-money (“bid,” price at which it is possible to sell it) is, the less liquid the state of liquidity of the security will be, since the spread becomes a real cost item (on a par with trading commissions, for example) capable of progressively penalizing the final return on the investment, to an extent of even more than 2 percent.

Given that there are never any liquidity problems for Italian government bonds, for which extremely narrow bid-ask spreads can always be detected, here is a scale that may apply generally to describe a potential progressively decreasing state of liquidity:

1. Instruments admitted to trading on the MOT (the official market for bonds and government securities aimed mainly at retail) and/or the multilateral trading circuit EuroTlx, both of which are regulated and under the Italian Stock Exchange-Euronext;
2. Bonds not traded on the MOT or EuroTlx, but for which Bloomberg or Reuters report indicative quotes from dealers;
3. Bonds for which, although no indicative quotations can be found, Bloomberg or Reuters give a fair price indication (i.e., an estimate of the price of the bond that is as objective as possible, disregarding its current market value);
4. Securities for which neither indicative quotations nor theoretical prices are detectable.

Credit risk, or default risk, refers to the possibility that the issuer of the bond will be unable to make interest payments or repay principal when due. This risk is higher for corporate bonds than for government bonds.

Connected to the probability that coupons or principal repayments will not be honored on time, credit risk is defined in the first instance by the rating (“rating”) assigned to the issuer, or to the specific bond issue, by the major international rating agencies (Moody’s, S&P, Fitch, and more remotely DBRS).

On the level of the rating, and whether it falls in the “investment grade” rather than “speculative grade” area (a kind of Series A and Series B of credit, respectively, while Series C is only practicable for specialists), depends the additional yield the market requires from the issuer to remunerate the higher or lower credit risk related to the issuer or the specific bond issue, if it is covered by rating.