Bonds: Two types of risks, three kinds of return

 Bondholder gets return from three sources if he buys and holds a bond till maturity. First there will be periodic interest payments, which are termed as coupon payments. If the holder wants to earn a compounded rate of return, he will have to reinvest these coupons have been reinvested till maturity, the investor would have earned simple interest. Interest obtained by reinvesting coupons is interest on interest.

            This reinvestment income is the second source of return for the bondholder. Finally, at maturity, the holder will get the face value back. If he had bought the bond at a price below par, then there would be a capital gain. Else if the bond had been trading at a premium at the time of purchase, there will be a capital loss. This capital gain is the third source of income for the bond holder.

Reinvestment Risks

One risk that every investor faces is reinvestment risk. This is the risk that the prevailing interest rate at the time of receipt of a coupon , is lower than what the holder had anticipated at the outset. This affects all bonds. The larger the coupon the greater the reinvestment risk, because the greater is the contribution of reinvestment income to the total return.

Consequently, premium bonds are more vulnerable to reinvestment risk than par bonds, while discount bonds are less vulnerable. This is because the former is characterized by high coupon compared to the prevailing yields, while for the later; the coupons are lower than the yields. Also, long term bonds are more vulnerable to reinvestment risk than shorter term bonds since longer the term to maturity; the greater is the contribution of reinvestment income to the total return.

Finally, the return also depends on tax factors. In many markets the coupons are taxed. The issue with paying tax on coupons is that the investor not only gets a lower post-tax amount, he consequently, has less to invest, and gets a lower interest. And the interest earned by reinvesting the coupons, will itself be subject to income tax.

Second, if there is a capital gain at maturity that too may attract a tax. In many countries, the rate of tax applied to income differs from that applied to capital gains. Also, some countries make a distinction between short term and long term capital gains.  An investor may be able to get an indexation benefit while computing his or her capital gain. That is, the quantum of the original investment can be scaled up for inflation, and the capital gain is then computed with respect to this adjusted investment.

Price Risk

A trader who sells the bond prior to maturity not only faces reinvestment risk, but also faces price risk. That is if the yields are high at the time of sale, the selling price may be lower than anticipated. Remember, the face value will be received only if the bond is held to maturity. Prior to that the holder will receive the market price, which may be lower or higher. The two risks work in opposite directions. Reinvestment risk impacts an investor if rates fall, while price risk hurts him if rates rise.