Investing in treasury bonds - what are the risks?

Investing in treasury bonds

Bonds are usually perceived as a safe investment, in particular when compared to shares. However, when investing in bonds, it is important to be aware that they are not entirely risk-free.

The safest group of bonds are securities issued by the State Treasury, but even these bonds involve a certain amount of risk. Let us therefore analyse what we need to pay attention to,  if we want to invest money in bonds.

Investment in treasury bonds

The bonds are closely related to the interest rate risk. Bond prices and interest rates tend to move in the opposite direction. An increase in the interest rate usually leads to a fall in the market price of the bonds. The reason for this is simple. Investors interested in buying bonds in the event of an interest rate increase in the market will want to dispose of their bonds as soon as possible, since newly issued bonds offer a better rate of return - an increased supply of bonds will lead to a decline in their market value.

In turn, the opposite situation, i. e. a decrease in interest rates, will lead to an increase in the price of bonds, as investors will be interested in buying such bonds because their yield is higher than those currently issued. An exception to this rule are floating rate bonds, whose coupons increase as interest rates rise. In this case, interest rate changes do not affect the price of the bonds or the impact of their changes is very limited. Fixed-rate bonds and zero coupon bonds with long maturities are the most exposed to interest rate risk

A commonly used measure of sensitivity to interest rate changes is duration. Duration is the weighted average waiting period for cash inflows from bonds.

When an investor buys bonds, he agrees to receive an interest rate - fixed or variable - at the time when he holds the bonds. Over this period, inflation may turn out to be on the rise, leading to a fall in the real value of money and its purchasing power. Such a situation may even lead to a situation where the investor, despite receiving interest on the bonds, is actually incurring a loss because the inflation rate is higher than the yield of the bonds.

A bond is a debt paper....

A bond is a debt paper, which means that the investor grants the issuer a loan which should be returned with interest. The bondholder therefore bears the credit risk of the issuer of the bond. While treasury bonds are usually considered to be free from such risks, corporate bonds are no longer guaranteed by the State. The investor should be aware that the receipt of periodic payments, as well as a nominal value, depends on the company's ability to repay its debt on time.

Consideration should also be given here to the likelihood of a company going bankrupt or temporarily losing liquidity. Aid to the investor may be provided by rating agencies which measure the ability of companies to service their debt. A credit rating downgrading or bankruptcy is another risk associated with an investment in treasury bonds. A lower company rating means a higher risk of investing in securities issued by a given entity - investors will therefore expect a higher risk premium, which will lead to higher profitability and lower prices of treasury bonds of a given issuer.

There is one more risk related to the holding of treasury bonds, or rather their disposal - liquidity risk. An investor wishing to sell his treasury bonds may sometimes have liquidity problems on a shallow market and may not be able to sell the bonds at their actual market value or may be forced to wait for the sale of treasury bonds longer than in the case of liquid assets.