Well, well. I closed my last article by saying “Summer is a-coming.” Little did I know that my weather forecasting skills were so advanced! Having said that, by the time you read this, we may have had weeks of storm and floods. Such are the risks of the English weather, and risk is still the subject of my meanderings.
I touched upon Government risk in the last edition, and this is still an issue where we are discussing the bonds issued by various governments. The more stable that an administration is perceived to be, economically and politically, the lower the risk (and potentially lower the return) is likely to be. Individual countries’ interest rate policy will, of course, have a bearing on the returns available. It has long been considered in the Western world, that the risk of a government defaulting on its debt obligations is fairly low. However, the difficulties that have been encountered in Greece, and to a lesser degree Ireland, Portugal and Spain, have made us more aware of the possibility that government securities might not be absolutely safe. It is fair to say that none of the above have defaulted on any debts, but simply that some economists have mooted the idea that this might be a possible scenario, has meant that the perception of risk has increased, and hence the yield available increased to reflect this.
Bonds issued by companies have a greater degree of risk than those issued by most governments (though a blue-chip multi-national would probably have a better credit rating than a third-world ‘banana republic’) so, normally, they have a higher potential return to reflect this added risk. The risks affecting such ‘corporate bonds’ are, principally, economic ones. Fund managers that run funds containing such bonds are supported by analysts, whose sole (working) purpose is to assess the strengths and weaknesses of the various companies, in which the manager may invest. This will, hopefully, produce above-average returns with lower risks. The ‘credit risk’ reflects the strength and stability of the company, and its ability to make the regular payments on the bond, and eventually repay the capital to the investor. Whilst bonds are often looked upon as being low-risk, the last couple of years have shown us that in certain economic circumstances, they can be anything but. During the recent ‘credit crunch’ there was such concern about the ability of companies to fulfil their financial obligations, that the value of many corporate bonds plummeted, giving many investors a nasty shock!
There is another major risk to bonds, and the funds that invest in them: that of the prevailing interest rates. If local interest rates go down, then the market adjusts the capital value of the bond up, so the yield from it equals the relevant interest rate. Similarly, if interest rates rise, then the capital value of bonds will tend to go down. It seems that what started as an offhand comment, has turned into an epic, so I shall pause at this point and continue the ‘risk story’ in a couple of months. Have a super Summer!