Credit risk is the potential for loss resulting from an actual or perceived deterioration in the financial health of the issuing company. Two subcategories of credit risk are default risk and downgrade risk.
Interest rate risk affects fixed-income security prices, mainly when interest rates rise. Since prices of all market-traded bonds move counter to the direction of rates, rising rates cause bond prices to decline. Longer-maturity bonds are the most vulnerable.
Liquidity refers to the investor’s ability to sell a bond quickly and at an efficient price, as reflected in the bid-ask spread. A difference may exist between the prices buyers are bidding and the prices sellers are asking on large, actively traded bond issues. The gap is often small, producing greater liquidity. As the spread rises on less actively traded bonds, so does liquidity risk. High-yield bonds can sometimes be less liquid than investment-grade bonds, depending on the issuer and the market conditions at any given time.
Economic risk describes the vulnerability of a bond to downturns in the economy. For example, in 2008, when the fuel price increased, causing inflation rise to 12%, force the Indonesian Government to increase interest rate up to 9%, the principal value and the total return of high-yield bonds declined significantly. Virtually all types of high-yield bonds are vulnerable to economic risk. In recessions, high-yield bonds typically lose more principal value than investment-grade bonds.
Company and industry “event” risk encompasses a variety of pitfalls that can affect a company’s ability to repay its debt obligations on time. These include poor management, changes in management, failure to anticipate shifts in the company’s markets, rising costs of raw materials, regulations and new competition. Events that adversely affect a whole industry can have a blanket effect on the bonds of its members.