Any type of money investment involves some level of risk that must be managed appropriately to mitigate the potential losses involved. It is important to understand the basics of these investment risks to ensure you know how to deal with them.
Market risk affects any type of individual security investment and describes the potential for a decrease in the value of the investment based on changes in market factors.
This risk is most often seen during periods of recession, which force investors to sell bonds and other assets in order to cover the costs of credit obligations.
Those who invest in individual bond portfolios are generally immunized against market risk, as the principals at maturity don’t change, even if the prices of the bonds do so.
Interest Rate Risk
Interest rate risk is another important factor in investment risks. Interest rates are governed by systemic changes in the market.
Interest rate increases, which can occur due to Federal Reserve Board hikes or market conditions, result in the market price of the bond decreasing.This occurs due to the opportunity cost of a particular bond.
Essentially, the value of the bond decreases since the investor could see a greater yield by switching to an investment to which a higher interest rate pertains. Conversely, lower interest rates increase the value of the bond due to the fixed rate of return.
This means that investors who hold individual bond portfolios until maturity decrease their interest rate risk.
Investment risks known as credit risk is directly related to the potential for loss when investing in bonds.
Credit risk increases when purchasing bonds from issuers who must depend on future cash flows to pay off current debts. This ability for the borrower to repay debts is based on calculations that include current assets, taxes and their ability to generate revenue.
Purchasing bonds from issuers with a low credit rating results in higher interest rates and the potential for increased profit. However, there is also an increased risk that the borrower will not be able to pay back the loan at maturity.
There is also an increased risk for companies with lower credit ratings to go bankrupt, which can have a significant impact on investment returns.
When considering investment risks, another important factor is inflation.
Inflation risk occurs in relation to the overall buying power of the dollar.
While some inflation is required for a healthy economy, it can become problematic if it is not controlled as it can lead to corporate managers and individual investors being unable to determine potential returns properly.
Bonds are the most vulnerable to these kinds of investment risks.
While there are other types of risks involved with investing, these are the most important to consider as they can have a considerable impact on return rates.
Understanding these risks and how they can affect your investments is the first step in making sure you have a strong basis in which to being investing.