Issuers of Bonds: An Overview - Their Roles, Purposes, and Categories
When it comes to investing in bonds, there are several types to choose from, each with its own unique characteristics and risks. Two main factors to consider when making a decision are your risk tolerance and investment goals. These factors will help determine the type of bonds suitable for your portfolio.
Key Factors Based on Risk Tolerance and Investment Goals
Credit Risk (Default Risk)
Sovereign bonds, issued by stable governments, generally carry the lowest credit risk, especially when denominated in the government's native currency. However, sovereign bonds issued in foreign currency may add currency risks. Local government or quasi-government bonds typically have moderate credit risk depending on the issuer's financial health and backing by government authorities. Supranational bonds, issued by organizations like the World Bank, often have strong credit quality due to multilateral backing, thus relatively low risk. Corporate bonds vary widely, with investment-grade corporates having moderate risk, while high-yield (junk) corporates involve higher default risk but offer higher yields to compensate.
Yield and Return Expectations
Riskier bonds, like high-yield corporate bonds or emerging market sovereign bonds, tend to offer higher interest rates to attract investors willing to take on more risk. Safer bonds, such as investment-grade sovereign debt or supranational bonds, generally provide lower yields but more stable returns.
Interest Rate Risk
Long-term bonds have higher sensitivity to interest rate changes, increasing price volatility. Short-term bonds are more stable but usually yield less. Investors with lower risk tolerance or shorter investment horizons often prefer short-term or intermediate-maturity bonds to reduce volatility risk.
Currency Risk
Bonds issued in foreign currencies, particularly sovereign bonds in international markets, expose investors to currency fluctuations, which can affect returns either positively or negatively.
Liquidity and Market Access
Sovereign and supranational bonds generally have better liquidity and more transparent pricing. Local or quasi-governmental bonds may have less liquidity. Corporate bonds' liquidity varies with issuer size and credit rating.
Investment Horizon and Goals
For capital preservation and steady income, low-risk bonds like sovereign or highly rated supranational issues align better. For growth-oriented goals, adding riskier bonds like high-yield corporates or emerging market bonds may increase returns while accepting more volatility.
Summary Table
| Bond Type | Typical Risk Level | Yield Level | Key Risks | Suitability by Investor Goal | |---------------------|-----------------------------|----------------------|------------------------------------|--------------------------------------------| | Sovereign (native currency) | Low | Low | Minimal default risk | Risk-averse, capital preservation | | Sovereign (foreign currency) | Moderate (currency risk) | Moderate | Currency fluctuations, default risk in weaker countries | Diversification, moderate risk tolerance | | Supranational | Low to moderate | Moderate | Very low default risk | Low risk tolerance, steady income | | Local/quasi-governmental | Moderate | Moderate | Credit risk, less liquidity | Moderate risk tolerance | | Corporate (investment grade) | Moderate Moderate–High | Moderate | Credit risk varies | Balanced growth and income | | Corporate (high-yield) | High | High | High default risk | High risk tolerance, growth-focused |
In conclusion, investors with low risk tolerance and conservative goals typically favor sovereign and supranational bonds. Those seeking higher yields and able to weather potential volatility may incorporate corporate (including high-yield) or certain local/quasi-governmental bonds into their portfolio. Currency exposure and interest rate sensitivity also significantly affect bond selection depending on the investor's profile.
In light of one's risk tolerance and investment goals, it is essential to consider various aspects of the bond market, such as credit risk, yield and return expectations, interest rate risk, currency risk, liquidity, and market access when making an informed decision on investing. For instance, investors aiming for capital preservation and steady income may opt for low-risk bonds like sovereign or highly rated supranational issues, while those with higher risk tolerance and a focus on growth might invest in riskier bonds like high-yield corporates or emerging market bonds for potentially higher returns.
