By Charles Ross, Contributor 
Ross
LAST week we established that bonds are fixed interest investments that give higher returns than money market investments and individual investors or institutions that are looking for fairly stable medium to long term investments would find them very attractive.
However, they do carry higher risks than money market investments. In this article, we explore what some of these risks are and how the investor can assess these risks and be guided by them in selecting and maintaining his or her investments. There are two principal risks associated with buying and holding bonds:
THE DEFAULT RISK
The possibility exists that the issuer of the bond may break some aspect of the bond contract. This may include ceasing payment of interest on the bond, not repaying the principal or seeking to change the terms of the agreement in ways that are detrimental to the bondholder.
THE PRICE RISK
There is a possibility that at the time the bondholder wishes to sell the bond, the price has fallen below the level at which it was bought. This exposes the investor to a capital loss on the investment.
THE DEFAULT RISK
The Default Risk is probably the largest risk that an investor in bonds faces as it may entail the loss of his entire principal. However, in most cases in which this threat looms, the issuer usually negotiates a hefty discount on the principal - resulting in repayment of a percentage of the principal, rather than repaying nothing at all. The Mechala bond which was issued in the US capital market some years ago provides an example of a default by the issuer, Mechala, followed by an offer from them to repay 35 per cent of the face value or principal of their bond. Further negotiations saw them settling at a repayment of about 45 per cent of the original face value of their bond.
THE PRICE RISK
This second risk usually involves much smaller potential losses for the bondholder. In fact, if the bondholder is prepared to hold the bond until maturity, the Price Risk can be avoided altogether provided that the issuer continues to honour their obligations with respect to the bond. It must be remembered that the ability to sell a bond whenever one wishes to is one of the great attractions of this type of investment. Also affecting how investors feel about bonds is the fact that bond prices do fluctuate according to changes in market sentiment, developments that affect the issuer, and even unfolding events in neighbouring or distant countries. This last effect is referred to as "contagion". In the normal course of things, price movements can be quite moderate, fluctuating by a few percentage points upward or downward. However, they can be quite dramatic at times especially among bonds that have lower credit ratings. Some Brazilian bonds that were issued at par or 100, fell recently to 53 as fears about the outcome of that country's upcoming presidential elections took hold of the market. After announcement of an agreement reached with the IMF, the price rallied to 69 before falling again.
RATING AGENCIES & RISK ASSESSMENT
There are many issuers of bonds on the international capital market. To help investors assess the risks associated with buying and holding these bonds, institutions known as Rating Agencies have emerged to rate these issuers and their bonds according to the level of risk that they carry. There are a number of such agencies but Standard and Poor (S&P) and Moody's are two of the most respected for the work they do in rating international sovereign and corporate bonds. The rating agencies have on their staff economists and analysts who try to determine the extent to which a particular issuer may or may not be able to service their Bond liabilities. When they have quantified this risk, they assign a rating to that issuer or to the bond itself, according to where the risk falls on the Agency's rating scale.
For example, S&P uses a system of ratings which range from AAA - its highest rating, given to issuers with an extremely strong capacity to meet their financial commitments - right down to SD or D, which are issuers that are in default. Their rating groups run in descending order as follows: AAA, AA, A, BBB, BB, B, CCC... D. S&P has given the US Federal Home Loan Bank, a government agency, an AAA rating; Barbados is rated A- or estimated to have a strong capacity to meets its financial obligations; and Trinidad is rated BBB- or having adequate capacity to meet its obligations. Jamaica's rating of B+ suggests that the country is more vulnerable to non-payment but is currently able to meet its commitments, although adverse economic conditions will likely impair the country's ability or willingness to continue to do so.
While the ratings are widely used in the investing community as a guide to the risk associated with a particular issuer, they are not totally reliable and do not always give a complete guide as to how the market will view and price the bonds of a particular country or company. In our next article we will look a little closer at the ratings and at some of the other factors affecting the risk associated with a particular country's bonds.
Charles Ross is Managing Director of Sterling Asset Management Ltd.
