Interest rate risk and credit risk are two important risks associated with investing in bonds. Understanding these risks is essential for making informed investment decisions and managing risk.
Interest rate risk is the risk that bond prices will decrease as interest rates rise. When interest rates rise, newly issued bonds will pay a higher yield, making existing bonds with lower yields less attractive. As a result, bond prices fall, leading to a potential loss for bondholders. The longer the maturity of a bond, the higher its sensitivity to interest rate changes, and the greater the interest rate risk.
Credit risk, on the other hand, refers to the risk that the issuer of a bond will default on its debt obligations. A default results in a loss of principal for the bondholder. The creditworthiness of the issuer is an important factor in determining the credit risk of a bond. A company or government with a higher credit rating is considered to be less risky and is likely to pay a lower yield than a company or government with a lower credit rating.
Bond investors can manage interest rate risk by investing in bonds with shorter maturities or by investing in bonds with floating interest rates that adjust to changes in the market. Credit risk can be managed by investing in bonds issued by high-credit-quality issuers and by diversifying investments across multiple issuers.
In conclusion, interest rate risk and credit risk are two important risks associated with investing in bonds. Understanding these risks and taking steps to manage them is essential for making informed investment decisions and achieving financial goals.
