The main risk taken by a debt investor is the so-called credit risk, that is, the possibility that the issuer may not be able to meet its future coupon payment and / or principal repayment commitments.
For the most solvent issuers, the investor will not experience losses if they hold the securities until maturity.
An approximation to credit risk is given by the risk premium, which is the yield spread between a government debt security issued by a given State, and the yield of government fixed income issued by the State with the highest credit rating.
Notwithstanding the foregoing, this does not imply that the aforementioned debt from solvent issuers is completely exempt from other possible risks other than the issuer’s solvency, such as:
- Interest rate or market risk: There is an inverse relationship between the price of bonds and the interest rate, so that if interest rates rise, the market value of the bond decreases in order to be competitive with new issuances, which offer higher interest. In this case, if the holder sells it before maturity, they will incur a loss (capital loss), recovering the invested capital if they hold it until maturity.
A very useful indicator for evaluating the market risk of a debt portfolio is the so-called duration. The duration reflects the weighted average maturity of the financial flows expected by the portfolio; therefore, it shows the sensitivity of the price to changes in interest rates. Longer duration means greater risk, because in the event of increases or decreases in interest rates, the value of fixed income will vary with greater intensity.
- Currency risk: To be taken into account when debt securities are denominated in a currency different from that of the investor, given the probability that it will be depreciated or devaluated.
- Inflation risk: Consisting of the reduction of the purchasing power of future coupons. The coupon to be received can be fixed or variable. In the latter case there are multiple types, among others:
- Increasing coupon, increases as the security expires.
- Decreasing, decreases as the maturity of the security approaches.
- Indexed, that is, the coupon is related to a reference index, so that increases or decreases in said index will determine the final yield to be received.
- Liquidity risk: Liquidity will depend on the size of the issuance, so that the larger the issuance, the higher its liquidity. And this to the extent that there will be a higher number of investors who want to operate in the market both in the role of buyers and sellers, that is, a greater market breadth.
- Prepayment risk: It occurs when the debt issuer reserves in the clauses of the issuance the power to prepay unilaterally the debt issued. It occurs in some issuances of government or corporate debt, in which, when the interest rate drops continuously, the issuer may be interested in prepaying.
The risk of fixed income linked to the credit quality or solvency of the issuer of the security is valued through the ratings granted by international rating agencies, which are represented by a system of letters:
- AAA, AA, A, BBB, for “investment grade” issuers.
- BB, B, CCC, CC, C and D, for issuers known as non-investment grade or, more colloquially, “junk bonds”.
The higher the credit rating, the greater the probability of recovering the investment and collecting the coupons on the established dates. In the same way, a priori, the lower the return will be, given the lower risk taken.
Some risks, such as currency or market risks, can be fully or partially hedged with other financial instruments.
