Credit Risk Or Default Risk
Credit or default risk, refers to the risk that the issuer of a fixed income security may default (The issuer will be unable to make timely principal and interest payment on the security). Credit risk is gauged by quality ratings assigned by commercial rating companies as well as credit research staff of investment banking firms & institutional investor concerns.
Because of this risk, most bonds are sold at a lower price than or at a yield spared to comparable. US Treasury securities which are considered free of credit risk however except for the lowest credit securities (Known as “high-yield” or “Junk bonds” the investors is normally concerned more with the changes in the perceived credit risk &/or the cost associated with a given level of credit risk than with the actual vent of default. This is so because even though the actual default of an issuing corporation may be highly unlikely, the impact of the change on perceived credit risk or the spread demanded by the market for any given level of risk can have an immediate impact on the value of security.
In many situations, a bond of a given maturity is used as an alternative to another bond of different maturity. An adjustment is to account for the differential interstate risks in the two bonds. However, this adjustment makes an assumption about how the interest rates (yields) at different maturities ell move. In the extent that the yields movements deviate form this assumption, there is yield-curve or maturity risk.
In general, yield-curve risk is more important is hedging situations rather than in pure investment decisions. For example, if a trader is hedging a position or if a pension fund or an insurance company is acquiring assets so as to unable it to meet a given liability, then yield-curve risk should be carefully examined. However, if a pension fund has decided to invest in the intermediate-term sector, then the fine distinctions in maturity are less important.
Another situation where yield-curve risk should be considered is in the analysis or bond swap transactions where the potential incremental returns are dependent entirely on the parallel shift (or other regularly arbitrary) as summation for the yield curve.
Inflation risk or purchasing power risk arises because of the variation in the value of cash flows from a security due to inflation as measured in terms of purchasing power.
For example, if an investor purchases a five year bond in which he or she can realize a coupon rate of 7%, but the rate of inflation is 8%, then the purchasing power of the cash flow has declined.
For all but adjustable or floating rate bonds, an investor are exposed to inflation risk because the issuer promises to make is fixed for the life of security. To the extent that interest rates reflects extend to make is fixed for the life of the security. Floating rate bonds have a lower level of inflation risk.
Marketability risk, or liquidity risk, involves the case with which an issue can be sold at or near its true value. The primary measure of marketability, liquidity is the size of the spared between the bid of price and the offer price and the offer quoted by a dealer. The greater the dealer spared the grater the marketability liquidity risk. For an investor who plans to hold the bond until the maturity date marketability/liquidity risk is less.
