Fixed income securities are often seen as the ‘ballast’ of portfolios, holding their value through periods when other assets are falling. But bonds carry inherent risks as well, and failing to account for these can leave portfolios exposed.

Uncertainty over the trajectory of interest rates, the spectre of sovereign defaults, and less abundant liquidity are all features of the current market that pose risks to bond holders. They are also concerns that many investors have never had to worry about in their lives.

Zenith Investment Partners head of multi-asset and fixed income research Andrew Yap broadly groups the risks to fixed income securities into four categories: interest rate risk, default risk, liquidity risk and spread volatility risk.

After decades of steady and accommodating monetary policy around the world, interest rate risk had become almost a forgotten aspect of investing in bonds, until a post-pandemic surge in inflation dramatically changed the outlook.

Rising interest rates cause the market value of bonds to fall, so investment managers need to form a forward view of where interest rates may be in the future, Yap explains. Investors take shorter duration positions when interest rates are expected to rise, and longer duration positions when they are expected to fall.

With a lack of consensus currently about the trajectory of interest rates, this can be challenging. “With interest rates moving so aggressively, interest rate management is presently a key area of focus,” Yap tells Professional Planner.

Another risk currently dominating the headlines is default risk, where an issuer goes bankrupt or insolvent, and in the worst-case investors lose their money. With the US approaching its US$31.4 trillion ($2.08 trillion) debt ceiling, investors have been sorely reminded that even the most trustworthy issuers are not completely immune to default.

A default dramatically changes the way a bond is rated, and therefore its investment characteristics, Yap explains.

“Default risk can be tied to the credit ratings assigned by independent credit rating agencies such as Standard & Poors and Moodys,” Yap says.

“The lower the credit rating, the higher the assumed default risk and, by consequence, the higher the return demanded by investors to be compensated for the risk.”

Liquidity risk reflects the ability of an investor to transact a bond. If an investor needs to sell a bond in a hurry, the price may not be ideal, Yap says, particularly for lower grade bonds that are less liquid, such as some emerging market bonds.

“If markets are illiquid… perhaps in a risk-off environment such as the GFC or Covid-19, then it’s hard to sell down a position and this may necessitate the holder of the bonds to take a haircut on the price they get,” Yap says.

Lastly, spread volatility risk refers to whether the movement in the price of a bond is stable. In times of volatility, investors seek further compensation for this, Yap says.