7 Risks Associated with investing in Debt Securities: What Are They?

What are debt securities?

Debt securities are referred to as debt instruments that are brought or sold between two parties with basic terms defined. The basic terms include the Notional Amount (i.e. the borrowed principal), as well as the interest rate, and the dates (both, maturity date and the date at which the bond can be renewed).

Therefore, debt securities can be defined as financial assets that make it liable for the issuer to pay the owners a stream of interest-based payments. However, they are different from equity securities in the way that they make the owner liable to repay the principal amount that is borrowed. The interest rate of the debt instrument is contingent on the credibility (i.e. creditworthiness) of the borrower. Hence, high-risk entities bear higher interest rates whereas low-risk entities bear lower interest rates.

Examples of Debt Securities

Some examples of debt securities include the following:

Risks associated with Debt Securities

There are several different risks that are associated with bonds, and debt securities in general. These risks are summarized below:

1. Interest Rate Risk and Bond Prices

Normally, there is an inverse relationship between interest rates and the underlying debt security price. With falling interest rates, bond prices normally rise. On the other hand, when interest rates increase, bond prices also decrease.

Therefore, from an investor’s perspective, there is always an inherent interest rate risk that is likely to impact the underlying price of the security. For example, if the prevailing interest rate has an upward trajectory, investors are likely to go towards bonds with lower interest rates. Hence, the bond prices will go down as a result.

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2. Reinvestment Risk

Reinvestment risk is referred to as the risk of having to reinvest bond proceeds at lower rates when funds were received with previous earnings. One of the main reasons where the risk represents itself is when the interest rates decrease over the course of time and the call feature is exercised by the issuer of the bond.

The callable bond feature is in place to allow the issuer to redeem the bond at an earlier date as compared to the maturity date. Consequently, the bondholder receives the principal payment, which is higher as compared to the par value of the bond. However, the downside to the bond call is the fact that the investor is mostly left with cash money that cannot be reinvested at a comparable rate. The reinvestment risk, therefore, implies that the investor might not find investment options at comparable rates.

However, to mitigate this risk, investors mostly receive a higher yield on the bond than they would on a similar bond that is callable.

3. Inflation Risk

When an investor purchases a bond, they mostly commit to receiving a rate of return, that is either fixed or variable, for the time when the bond is held. In the case where the cost of living and inflation increases on an exponential basis, the overall purchasing power significantly goes down. Therefore, in the case of increasing inflation rates, the real rate of return on bonds is actually negative.

For example, if an investor has a bond that bears interest of 3%. In case the inflation rate is 5% after the bond has been purchased, the investor’s actual (or real) rate of return comes to -2%, owing to the decrease in the purchasing power.

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4. Credit (or Default) Risk

A bond purchase is similar to purchasing a certificate of debt. This is the borrowed money that the debt owner must pay over the course of time with interest. Investors are also supposed to consider the possibility of default and credit risk that goes into the bond purchase.

Credit Risk is mainly the risk of the debtholder not being able to meet the interest expenses or the principal repayments. Therefore, when considering such investments, debtholders determine the coverage ratio of the company before initiating an investment. This is also coupled with an analysis pertaining to income and cash flow statements, which further determines its operating income and cash flow.  

5. Rating Downgrades

Credit ratings tend to be a very important factor in terms of determining the creditworthiness of a given debtholder. The credit rating is mostly evaluated using the credit ratings of institutions using S&P Ratings, or Moody’s Ratings Scale.

The decisions and the credit ratings made by these institutions place a very heavy burden on the investors. Subsequently, in the case where the credit rating is low, or the ability to meet operational day-to-day expenses is low, it has a very significant impact on the debtholders. This adversely impacts the ability of the company to satisfy its debts, and hence, from an investor’s perspective, this holds a very major risk.

6. Liquidity Risk

Liquidity Risk is referred to the risk of the investor being unable to sell the bonds due to lack of demand. Lower interest rates, for example, impact the price of the bond, and hence, the marketability. Therefore, the investors have an inherent liquidity risk associated with bonds, which hamper them to sell it off in the market. This implies that their funds are tied up in the stocks, in an unwarranted manner.

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7. Market Risk

This is also one of the most significant risks that are associated with debt securities. The overall macroeconomic environment greatly impacts the positioning of the bond. These are other factors that impact the positioning of the debt covenants.

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