Risk in Bond Valuation

Bonds provide diversification and steady income to investors but carry various risks.

Bonds carry common risks such as default, interest rate, liquidity, market, and inflation risks.

Consider Sarah. She buys a ten-year corporate bond from Freshly Corp, which has a face value of one thousand dollars and an annual coupon rate of five percent. 

Over time, she learns about the risks linked to her investment.

Default or credit risk arises if Freshly Corp cannot make regular interest payments or repay the principal at maturity.

Interest rate risk refers to the decline in Freshly's bond market price as new bonds with higher yields become more attractive.

Liquidity risk occurs when Sarah can not sell bonds easily at a fair price, especially during market stress.

This can lead to difficulties in converting bonds to cash without significant losses.

Her investment also faces market risk, where the bond's value fluctuates.

Sarah also faces inflation risk, where her returns may fall below inflation rates.

Diversifying investments across industries and managing liquidity are key strategies for bond investors like Sarah.