(a) All investments offer a balance between risk and potential return. The bond market is no exception to this rule.
(i) Discuss reasons why bonds are considered less risky than stocks.
(ii) Explain determining factors which make bonds a high yielding and perfect choice for investors.
(b) Describe the risks associated with investing in government and corporate bonds.
Explain the term ‘beta of a stock measure’?
a) (i) Bonds are less risky compared to stocks for several reasons: Stocks sometimes pay dividends, however, their issuer has no mandate to make these payments to shareholders. Over a long time, the bond market has minimal vulnerability to price swings or volatility than the stock market.
ii) These bonds pay higher interest rates because they have lower credit ratings than investment-grade bonds.
High-yield corporate bonds are always punctual and pay back much higher returns than their investment-grade counterparts.
Relatively low duration –
High yield bonds often have relatively low duration since they tend to have shorter maturities; they are typically issued with terms of 10 years or less and are often callable after four or five years.
b) Interest rate risk.
Interest rates have an inverse relationship with bond prices. Therefore, if you buy a bond, you commit to receiving a fixed rate of return (ROR) for a set period.
Government Bonds have the following limitations: The interest paid on bonds or the 'yield' can be low. Bonds can lose value on the open market if interest rate or inflation expectations rise. This is because higher interest rates or higher inflation make the fixed interest paid by bonds less attractive.
Furthermore, the bonds usually don't deliver returns as high as riskier types of investments.
For bond investors inflation risk need to be put into consideration. For instance you buy a 10-year bond with a 5% yield (and return of principal at the end), in a low inflation environment of 1-2%, for example, inflation risk is fairly low.
(c) Beta represent a measure of a stock's volatility in comparison to the overall market. If a stock moves slower than the market, the stock's beta is below than 1.0. High-beta stocks are supposed to be riskier but provide higher return potential; low-beta stocks pose less risk but also lower returns.