How to Calculate Bond Risk
Bonds are considered to be safer investments than stocks; ideally, upon the bond’s maturity, you should be repaid your initial investment. Further, the bond market tends to be less volatile than the stock market. That does not mean, however, that bonds are without risk.
There are several risk factors that affect bonds, some of which you will be able to anticipate before you make your investment and some you cannot. The trick is to gather as much information as you can and weigh the risks against the potential profits from the bond.
4 Steps to Calculate Bond Risk
1. Discover the potential risks.
Market fluctuations can impact the value of your bond. Bonds, as fixed income securities, move inversely with interest rates. Higher interest rates cause the value of bonds to fall. There is also a risk that the bond issuer will have to default on the bond, for any reason from poor business practices to a broader market decline.
There is also the risk of a “call,” meaning that the bond issuer “calls back” your bond before maturity, and you receive only the current market value. A call could lead you to lose on your initial investment, in addition to the periodic interest payments you would have received over the life of the bond if you had held it through maturity.
2. Learn the types of bonds.
Treasury bonds, issued by the Department of Treasury, carry the lowest risks as they are government backed. Municipal bonds are issued by state and local governments.
They are slightly riskier than treasury bonds. Corporate bonds are the riskiest, as the financial health of the company determines its ability to honor the bond. In all cases, the creditworthiness of the bond issuer is an indicator of risk.
3. Research the bond.
Check the bond’s S&P; (Standard and Poor’s) rating. S&P; is an independent firm that rates the security of a bond based on the creditworthiness of the bond issuer.
Bonds rated from AAA (the most secure) to BBB are considered to be reasonably safe investments. Bonds rated BB and below are speculative, meaning they are high risk. You can find ratings on the S&P; website.
4. Consider duration.
As it refers to bonds, duration describes the sensitivity of the bond value to market fluctuations. Duration takes into account the number of interest payments due on a bond and the amount of time until bond maturity.
The equation to calculate duration is extremely complicated and can vary depending on specific rules associated with your bond. The easiest way to calculate duration is to use an online duration calculator. Simply plug in the requested information, which can be found on your bond paperwork.
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